6 6 SOLD OUT Introduction: A Call to Arms by Harvey Rosenfield America s economy is in tatters, and the situation grows dire by the day. Nearly 600,000 Americans lost their jobs in January, for a total of 1.8 million over the last three Millions months. more will lose theirs over the next year no matter what happens. Students can no longer pursue a college education. Families cannot afford to see a doctor. Many Americans owe more on their homes than they are worth. Those lucky enough to have had pensions or retirement funds have watched helplessly as 25 percent of their value evaporated in What caused this catastrophe? As this report chronicles in gruesome detail, over the last decade, Wall Street showered Washington with over $1.7 billion in what are prettily described as campaign contributions. This money went into the political coffers of everyone from the lowliest mem- President, Consumer Education Foundation 1 Source: Center for Responsive Politics, <www.opensecrets.org>. ber of Congress to the President of the United States. The Money Industry spent another $3.4 billion on lobbyists whose job it was to press for deregulation Wall Street s license to steal from every American. In return for the investment of more than $5.1 billion, the Money Industry was able to get rid of many of the reforms enacted after the Great Depression and to operate, for Industry 1 $ to Politicians $ to Lobbyists Securities $512 million $600 million Commercial Banks $155 million $383 million Insurance Cos. $221 million $1002 million Accounting $81 million $122 million most of the last ten years, without any effective rules or restraints whatsoever. The report, prepared by Essential Information and the Consumer Education Foundation, details step-by-step many of the events that led to the financial debacle. Here are the highlights of our economic downfall: Beginning in 1983 with the Reagan Administration, the U.S. government acquiesced in accounting rules adopted by the financial industry that allowed banks and other corporations to take money-losing assets off their balance sheets in order to hide them from investors and the public. Between 1998 and 2000, Congress and the Clinton Administration repeatedly blocked efforts to regulate

7 SOLD OUT 7 financial derivatives including the mortgage-related credit default swaps that became the basis of trillions of dollars in speculation. In 1999, Congress repealed the Depression-era law that barred banks from offering investment and insurance services, and vice versa, enabling these firms to engage in speculation by investing money from checking and savings accounts into financial derivatives and other schemes understood by only a handful of individuals. Taking advantage of historically low interest rates in the early part of this decade, shady mortgage brokers and bankers began offering mortgages on egregious terms to purchasers who were not qualified. When these predatory lending practices were brought to the attention of federal agencies, they refused to take serious action. Worse, when states stepped into the vacuum by passing laws requiring protections against dirty loans, the Bush Administration went to court to invalidate those reforms, on the ground that the inaction of federal agencies superseded state laws. The financial industry s friends in Congress made sure that those who speculate in mortgages would not be legally liable for fraud or other illegalities that occurred when the mortgage was made. Egged on by Wall Street, two government-sponsored corporations, Fannie Mae and Freddie Mac, started buying large numbers of subprime loans from private banks as well as packages of mortgages known as mortgage-backed securities. In 2004, the top cop on the Wall Street beat in Washington the Securities and Exchange Commission now operating under the radical deregulatory ideology of the Bush Administration, authorized investment banks to decide for themselves how much money they were required to set aside as rainy day reserves. Some firms then entered into $40 worth of speculative trading for every $1 they held. With the compensation of CEOs increasingly tied to the value of the firm s total assets, a tidal wave of mergers and acquisitions in the financial world 11,500 between 1980 and 2005 led to the predominance of just a relative handful banks in the U.S. financial system. Successive administrations failed to enforce antitrust laws to block these mergers. The result: less competi-

8 8 SOLD OUT tion, higher fees and charges for consumers, and a financial system vulnerable to collapse if any single one of the banks ran into trouble. Investors and even government authorities relied on private credit rating firms to review corporate balance sheets and proposed investments and report to potential investors about their quality and safety. But the credit rating companies had a grave conflict of interest: they are paid by the financial firms to issue the ratings. Not surprisingly, they gave the highest ratings to the investments issued by the firms that paid them, even as it became clear that the ratings were inflated and the companies were in precarious condition. The financial lobby made sure that regulation of the credit ratings firms would not solve these problems. None of these milestones on the road to economic ruin were kept secret. The dangers posed by unregulated, greed-driven financial speculation were readily apparent to any astute observer of the financial system. But few of those entrusted with the responsibility to police the marketplace were willing to do so. And as the report explains, those officials in government who dared to propose stronger protections for investors and consumers consistently met with hostility and defeat. The power of the Money Industry overcame all opposition, on a bipartisan basis. It s not like our elected leaders in Washington had no warning: The California energy crisis in 2000, and the subsequent collapse of Enron at the time unprecedented was an early warning that the nation s system of laws and regulations was inadequate to meet the conniving and trickery of the financial industry. The California crisis turned out to be a foreshock of the financial catastrophe that our country is in today. It began with the deregulation of electricity prices by the state legislature. Greased with millions in campaign contributions from Wall Street and the energy industry, the legislation was approved on a bipartisan basis without a dissenting vote. Once deregulation took effect, Wall Street began trading electricity and the private energy companies boosted prices through the roof. Within a few weeks, the utility companies unable because of a loophole in the law to pass through the higher prices to consumers simply stopped paying for the power. Blackouts ensued. At the time, Californians were chastised for having caused the shortages through over-consumption. But the energy shortages were orchestrated by Wall Street rating firms, investment banks and energy companies, in order to force California s taxpayers to bail out the utility companies.

9 SOLD OUT 9 California s political leadership and utility regulators largely succumbed to the blackmail, and $11 billion in public money was used to pay for electricity at prices that proved to be artificially manipulated by Wall Street traders. The state of California was forced to increase utility rates and borrow over $19 billion through Wall Street firms to cover these debts. Its electricity trading activities under investigation, Enron s vast accounting shenanigans, including massive losses hidden in off-balance sheet corporate entities, came to light, and the company collapsed within a matter of days. It looked at the time as though the California deregulation disaster and the Enron scandal would lead to stronger regulation and corporate accountability. But then 9/11 occurred. And for most of the last decade, the American people have been told that our greatest enemy lived in a cave. The subsequent focus on external threats, real and imagined, distracted attention from deepening problems at home. As Franklin Roosevelt observed seventy years ago, our enemies of today are the forces of privilege and greed within our own borders. Today, the enemies of American consumers, taxpayers and small investors live in multimillion-dollar palaces and pull down seven-, eight- or even nine-figure annual paychecks. Their weapons of mass destruction, as Warren Buffett famously put it, were derivatives: pieces of paper that were backed by other pieces of paper that were backed by packages of mortgages, student loans and credit card debt, the complexity and value of which only a few understood. Meanwhile, the lessons of Enron were cast aside after a few insignificant measures the tougher reforms killed by the Money Industry and Wall Street went back to business as usual. Last fall, the house of cards finally collapsed. For those who might have heard the blame the victim propaganda emanating from the free marketers whose philosophy lies in a smoldering ruin alongside the economy, the report sets the record straight: consumers are not to blame for this debacle. Not those of us who used credit in an attempt to have a decent quality of life (as opposed to the tiny fraction of people in our country who truly got ahead over the last decade). Nor can we blame the Americans who were offered amazing terms for mortgages but forgot to bring a Ph.D. and a lawyer to their closing, and later found out that they had been misled and could not afford the loan at the real interest rate buried in the fine print. Rather, America s economic system is at or beyond the verge of depression today because gambling became the financial sector s principal preoccupation, and the pile of chips grew so big that the Money Industry displaced real businesses that provided real

10 10 SOLD OUT goods, services and jobs. By that time, the amount of financial derivatives in circulation around the world $683 trillion by one estimate was more than ten times the actual value of all the goods and services produced by the entire planet. When all the speculators tried to cash out, starting in 2007, there really wasn t enough money to cover all the bets. If we Americans are to blame for anything, it s for allowing Wall Street to do what it calls a leveraged buy out of our political system by spending a relatively small amount of capital in the Capitol in order to seize control of our economy. Of course, the moment the Money Industry realized that the casino had closed, it turned as it always does to Washington, this time for the mother of all favors: a $700 billion bailout of the biggest financial speculators in the country. That s correct: the people who lost hundreds of billions of dollars of investors money were given hundreds of billions of dollars more. The bailout was quickly extended to insurance companies, credit card companies, auto manufacturers and even car rental firms. In addition to cash infusions, the government has blown open the federal bank vaults to offer the Money Industry a feast of discount loans, loan guarantees and other taxpayer subsidies. The total tally so far? At least $8 trillion. Panicked by Wall Street s threat to pull the plug on credit, Congress rebuffed efforts to include safeguards on how taxpayer money would be spent and accounted for. That s why many of the details of the bailout remain a secret, hiding the fact that no one really knows why certain companies were given our money, or how it has been spent. Bankers used it pay bonuses, to buy back their own bank stock, or to build their empires by purchasing other banks. But very little of the money has been used for the purpose it was ostensibly given: to make loans. One thing is certain: this last Washington giveaway the Greatest Wall Street Giveaway of all time has not fixed the economy. Meanwhile, at this very moment of national threat, the banks, hedge funds and other parasite firms that crippled our economy are pouring money into Washington to preserve their privileges at the expense of the rest of us. The only thing that has changed is that many of these firms are using taxpayer money our money to do so. That s why you won t hear anyone in the Washington establishment suggest that Americans be given a seat on the Board of Directors of every company that receives bailout money. Or that America s economic security is intolerably jeopardized when pushing paper around constitutes a quarter or more of our economy. Or that credit default swaps and other derivatives should

11 SOLD OUT 11 be prohibited, or limited just like slot machines, roulette wheels and other forms of gambling. In most of the United States, you can go to jail for stealing a loaf of bread. But if you have paid off Washington, you can steal the life-savings, livelihoods, homes and dreams of an entire nation, and you will be allowed to live in the fancy homes you own, drive multiple cars, throw multi-million dollar birthday parties. Punishment? You might not be able to get your bonus this year or, worst come to worst, if you are one of the very unlucky few unable to take advantage of the loopholes in the plan announced by the Treasury Secretary Geithner, you may end up having to live off your past riches because you can only earn a measly $500,000 while you are on the dole. (More good news for corporate thieves: this flea-bitten proposal is not retroactive it does not apply to all the taxpayer money already handed out). Like their predecessors, Presidentelected Obama s key appointments to the Treasury, the SEC and other agencies are veterans of the Money Industry. They are unlikely to challenge the narrow boundaries of the debate that has characterized Washington s response to the crisis. So long as the Money Industry remains in charge of the federal agencies and keeps our elected officials in its deep pockets, nothing will change. Here are seven basic principles that Americans should insist upon. Relief. It s been only five months since Congress authorized $700 billion to bail out the speculators. Congress was told that the bailout would alleviate the credit crunch and encourage banks to lend money to consumers and small businesses. But the banks have hoarded the money, or misspent it. If the banks aren t going to keep their end of the bargain, the government should use its power of eminent domain to take control of the banks, or seize the money and let the banks go bankrupt. On top of the $700 billion bailout, the Federal Reserve has been loaning public money to Wall Street firms money at as little as.25 percent. These companies are then turning around and charging Americans interest rates of 4 percent to 30 percent for mortgages and credit cards. There should be a cap on what banks and credit card companies can charge us when we borrow our own money back from them. Similarly, transfers of taxpayer money should be conditioned on acceptance of other terms that would help the public, such as an agreement to waive late fees, and an agreement not to lobby the government. And, Americans should be appointed to sit on the boards of directors of these firms in order to have a say on what these companies do with our money to keep them from wasting it and to make sure they repay it.

12 12 SOLD OUT Restitution. Companies that get taxpayer money must be required to repay it on terms that are fair to taxpayers. When Warren Buffett acquired preferred shares in Goldman Sachs, he demanded that Goldman Sachs pay 10 percent interest; taxpayers are only getting back 5 percent. The Congressional Oversight Panel estimates that taxpayers received preferred shares worth about two-thirds of what was given to the initial bailout recipients. Even worse are the taxpayer loan guarantees offered to Citigroup. For a $20 billion cash injection plus taxpayer guarantees on $306 billion in toxic assets likely to impose massive liabilities on the public purse the government received $27 billion in preferred shares, paying 8 percent interest. Now the Obama administration has suggested that it might offer a dramatically expanded guarantee program for toxic assets, putting the taxpayer on the hook for hundreds of billions more. Regulation. The grand experiment in letting Wall Street regulate itself under the assumption that free market forces will police the marketplace has failed catastrophically. Wall Street needs to operate under rules that will contain their excessive greed. Derivatives should be prohibited unless it can be shown that they serve a useful purpose in our economy; those that are authorized should be traded on exchanges subject to full disclosure. Further mergers of financial industry titans should be barred under the antitrust laws, and the current monopolistic industry should be broken up once the country has recovered. Reform. It is clear that the original $700 billion bailout was a rush job so poorly constructed that it has largely failed and much of the money wasted. The federal government should revise the last bailout and establish new terms for oversight and disclosure of which companies are getting federal money and what they are doing with it. Responsibility. Americans are tired of watching corporate criminals get off with a slap on the wrist when they plunder and loot. Accountability is necessary to maintain not only the honesty of the marketplace but the integrity of American democracy. Corporate officials who acted recklessly with stockholder and public money should be prosecuted and sentenced to jail time under the same rules applicable to street thugs. State and local law enforcement agencies, with the assistance of the federal government, should join to build a national network for the investigation and prosecution of the corporate crooks. Return to a real economy. In 2007, more than a quarter of all corporate profits came

13 SOLD OUT 13 from the Money Industry, largely based on speculation by corporations operating in international markets and whose actions call into question their loyalty to the best interests of America. To recover, America must return to the principles that made it great hard work, creativity, and innovation and both government and business must serve that end. The spectacle of so many large corporations lining up for government assistance puts to rest the argument made by the corporate-funded think tanks and talking heads over the last three decades that government is the problem, not the solution. In fact, as this report shows, government has been the solution for the Money Industry all along. Now Washington must serve America, not Wall Street. Massive government intervention is not only appropriate when it is necessary to save banks and insurance companies. For the $20 billion in taxpayer money that the government gave Citigroup in November, we could have bought the company lock, stock and barrel, and then we would have our own credit card, student loan and mortgage company, run on careful business principles but without the need to turn an enormous profit. Think of the assistance that that would offer to Main Street, not to mention the competitive effect it would have on the market. And massive government intervention is what s really needed in the health care system, which private enterprise has plundered and then for so many Americans abandoned. Revolt. Things will not change so long as Americans acquiesce to business as usual in Washington. It s time for Americans to make their voices heard.

14 14 SOLD OUT Executive Summary Blame Wall Street for the current financial crisis. Investment banks, hedge funds and commercial banks made reckless bets using borrowed money. They created and trafficked in exotic investment vehicles that even top Wall Street executives not to mention firm directors did not understand. They hid risky investments in offbalance-sheet vehicles or capitalized on their legal status to cloak investments altogether. They engaged in unconscionable predatory lending that offered huge profits for a time, but led to dire consequences when the loans proved unpayable. And they created, maintained and justified a housing bubble, the bursting of which has thrown the United States and the world into a deep recession, resulted in a foreclosure epidemic ripping apart communities across the country. But while Wall Street is culpable for the financial crisis and global recession, others do share responsibility. 2 For the last three decades, financial regulators, Congress and the executive branch have steadily eroded the regulatory system that restrained the financial sector from acting on its own worst tendencies. The post-depression regulatory system 2 This report uses the term Wall Street in the colloquial sense of standing for the big players in the financial sector, not just those located in New York s financial district. aimed to force disclosure of publicly relevant financial information; established limits on the use of leverage; drew bright lines between different kinds of financial activity and protected regulated commercial banking from investment bank-style risk taking; enforced meaningful limits on economic concentration, especially in the banking sector; provided meaningful consumer protections (including restrictions on usurious interest rates); and contained the financial sector so that it remained subordinate to the real economy. This hodge-podge regulatory system was, of course, highly imperfect, including because it too often failed to deliver on its promises. But it was not its imperfections that led to the erosion and collapse of that regulatory system. It was a concerted effort by Wall Street, steadily gaining momentum until it reached fever pitch in the late 1990s and continued right through the first half of Even now, Wall Street continues to defend many of its worst practices. Though it bows to the political reality that new regulation is coming, it aims to reduce the scope and importance of that regulation and, if possible, use the guise of regulation to further remove public controls over its operations. This report has one overriding message: financial deregulation led directly to the financial meltdown. It also has two other, top-tier messages.

15 SOLD OUT 15 First, the details matter. The report documents a dozen specific deregulatory steps (including failures to regulate and failures to enforce existing regulations) that enabled Wall Street to crash the financial system. Second, Wall Street didn t obtain these regulatory abeyances based on the force of its arguments. At every step, critics warned of the dangers of further deregulation. Their evidence-based claims could not offset the political and economic muscle of Wall Street. The financial sector showered campaign contributions on politicians from both parties, invested heavily in a legion of lobbyists, paid academics and think tanks to justify their preferred policy positions, and cultivated a pliant media especially a cheerleading business media complex. Part I of this report presents 12 Deregulatory Steps to Financial Meltdown. For each deregulatory move, we aim to explain the deregulatory action taken (or regulatory move avoided), its consequence, and the process by which big financial firms and their political allies maneuvered to achieve their deregulatory objective. In Part II, we present data on financial firms campaign contributions and disclosed lobbying investments. The aggregate data are startling: The financial sector invested more than $5.1 billion in political influence purchasing over the last decade. The entire financial sector (finance, insurance, real estate) drowned political candidates in campaign contributions over the past decade, spending more than $1.7 billion in federal elections from Primarily reflecting the balance of power over the decade, about 55 percent went to Republicans and 45 percent to Democrats. Democrats took just more than half of the financial sector s 2008 election cycle contributions. The industry spent even more topping $3.4 billion on officially registered lobbying of federal officials during the same period. During the period : Accounting firms spent $81 million on campaign contributions and $122 million on lobbying; Commercial banks spent more than $155 million on campaign contributions, while investing nearly $383 million in officially registered lobbying; Insurance companies donated more than $220 million and spent more than $1.1 billion on lobbying; Securities firms invested nearly $513 million in campaign contributions, and an additional $600 million in lobbying. All this money went to hire legions of lobbyists. The financial sector employed 2,996 lobbyists in Financial firms employed an extraordinary number of former government officials as lobbyists.

16 16 SOLD OUT This report finds 142 of the lobbyists employed by the financial sector from were previously high-ranking officials or employees in the Executive Branch or Congress. These are the 12 Deregulatory Steps to Financial Meltdown: 1. Repeal of the Glass-Steagall Act and the Rise of the Culture of Recklessness The Financial Services Modernization Act of 1999 formally repealed the Glass-Steagall Act of 1933 (also known as the Banking Act of 1933) and related laws, which prohibited commercial banks from offering investment banking and insurance services. In a form of corporate civil disobedience, Citibank and insurance giant Travelers Group merged in 1998 a move that was illegal at the time, but for which they were given a two-year forbearance on the assumption that they would be able to force a change in the relevant law at a future date. They did. The 1999 repeal of Glass-Steagall helped create the conditions in which banks invested monies from checking and savings accounts into creative financial instruments such as mortgage-backed securities and credit default swaps, investment gambles that rocked the financial markets in Hiding Liabilities: Off-Balance Sheet Accounting Holding assets off the balance sheet generally allows companies to exclude toxic or money-losing assets from financial disclosures to investors in order to make the company appear more valuable than it is. Banks used off-balance sheet operations special purpose entities (SPEs), or special purpose vehicles (SPVs) to hold securitized mortgages. Because the securitized mortgages were held by an off-balance sheet entity, however, the banks did not have to hold capital reserves as against the risk of default thus leaving them so vulnerable. Off-balance sheet operations are permitted by Financial Accounting Standards Board rules installed at the urging of big banks. The Securities Industry and Financial Markets Association and the American Securitization Forum are among the lobby interests now blocking efforts to get this rule reformed. 3. The Executive Branch Rejects Financial Derivative Regulation Financial derivatives are unregulated. By all accounts this has been a disaster, as Warren Buffet s warning that they represent weapons of mass financial destruction has proven prescient. 3 Financial derivatives have 3 Warren Buffett, Chairman, Berkshire Hathaway, Report to Shareholders, February 21, Available at: <http://www.berkshirehathaway.com/letters/

17 SOLD OUT 17 amplified the financial crisis far beyond the unavoidable troubles connected to the popping of the housing bubble. The Commodity Futures Trading Commission (CFTC) has jurisdiction over futures, options and other derivatives connected to commodities. During the Clinton administration, the CFTC sought to exert regulatory control over financial derivatives. The agency was quashed by opposition from Treasury Secretary Robert Rubin and, above all, Fed Chair Alan Greenspan. They challenged the agency s jurisdictional authority; and insisted that CFTC regulation might imperil existing financial activity that was already at considerable scale (though nowhere near present levels). Then-Deputy Treasury Secretary Lawrence Summers told Congress that CFTC proposals cas[t] a shadow of regulatory uncertainty over an otherwise thriving market. 4. Congress Blocks Financial Derivative Regulation The deregulation or non-regulation of financial derivatives was sealed in 2000, with the Commodities Futures Modernization Act (CFMA), passage of which was engineered by then-senator Phil Gramm, R- Texas. The Commodities Futures Modernization Act exempts financial derivatives, including credit default swaps, from regulation and helped create the current financial crisis. 5. The SEC s Voluntary Regulation Regime for Investment Banks In 1975, the SEC s trading and markets division promulgated a rule requiring investment banks to maintain a debt-to-netcapital ratio of less than 12 to 1. It forbid trading in securities if the ratio reached or exceeded 12 to 1, so most companies maintained a ratio far below it. In 2004, however, the SEC succumbed to a push from the big investment banks led by Goldman Sachs, and its then-chair, Henry Paulson and authorized investment banks to develop their own net capital requirements in accordance with standards published by the Basel Committee on Banking Supervision. This essentially involved complicated mathematical formulas that imposed no real limits, and was voluntarily administered. With this new freedom, investment banks pushed borrowing ratios to as high as 40 to 1, as in the case of Merrill Lynch. This superleverage not only made the investment banks more vulnerable when the housing bubble popped, it enabled the banks to create a more tangled mess of derivative investments so that their individual failures, or the potential of failure, became systemic crises. Former SEC Chair Chris Cox has acknowledged that the voluntary regulation was a complete failure. 2002pdf.pdf>.

18 18 SOLD OUT 6. Bank Self-Regulation Goes Global: Preparing to Repeat the Meltdown? In 1988, global bank regulators adopted a set of rules known as Basel I, to impose a minimum global standard of capital adequacy for banks. Complicated financial maneuvering made it hard to determine compliance, however, which led to negotiations over a new set of regulations. Basel II, heavily influenced by the banks themselves, establishes varying capital reserve requirements, based on subjective factors of agency ratings and the banks own internal riskassessment models. The SEC experience with Basel II principles illustrates their fatal flaws. Commercial banks in the United States are supposed to be compliant with aspects of Basel II as of April 2008, but complications and intra-industry disputes have slowed implementation. 7. Failure to Prevent Predatory Lending Even in a deregulated environment, the banking regulators retained authority to crack down on predatory lending abuses. Such enforcement activity would have protected homeowners, and lessened though not prevented the current financial crisis. But the regulators sat on their hands. The Federal Reserve took three formal actions against subprime lenders from 2002 to The Office of Comptroller of the Currency, which has authority over almost 1,800 banks, took three consumer-protection enforcement actions from 2004 to Federal Preemption of State Consumer Protection Laws When the states sought to fill the vacuum created by federal nonenforcement of consumer protection laws against predatory lenders, the feds jumped to stop them. In 2003, as Eliot Spitzer recounted, during the height of the predatory lending crisis, the Office of the Comptroller of the Currency invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. 9. Escaping Accountability: Assignee Liability Under existing federal law, with only limited exceptions, only the original mortgage lender is liable for any predatory and illegal features of a mortgage even if the mortgage is transferred to another party. This arrangement effectively immunized acquirers of the mortgage ( assignees ) for any problems with the initial loan, and relieved them of any duty to investigate the terms of the loan. Wall Street interests could purchase, bundle and securitize subprime loans including many with pernicious, predatory terms without fear of liability for

19 SOLD OUT 19 illegal loan terms. The arrangement left victimized borrowers with no cause of action against any but the original lender, and typically with no defenses against being foreclosed upon. Representative Bob Ney, R-Ohio a close friend of Wall Street who subsequently went to prison in connection with the Abramoff scandal was the leading opponent of a fair assignee liability regime. 10. Fannie and Freddie Enter the Subprime Market At the peak of the housing boom, Fannie Mae and Freddie Mac were dominant purchasers in the subprime secondary market. The Government-Sponsored Enterprises were followers, not leaders, but they did end up taking on substantial subprime assets at least $57 billion. The purchase of subprime assets was a break from prior practice, justified by theories of expanded access to homeownership for low-income families and rationalized by mathematical models allegedly able to identify and assess risk to newer levels of precision. In fact, the motivation was the for-profit nature of the institutions and their particular executive incentive schemes. Massive lobbying including especially but not only of Democratic friends of the institutions enabled them to divert from their traditional exclusive focus on prime loans. Fannie and Freddie are not responsible for the financial crisis. They are responsible for their own demise, and the resultant massive taxpayer liability. 11. Merger Mania The effective abandonment of antitrust and related regulatory principles over the last two decades has enabled a remarkable concentration in the banking sector, even in advance of recent moves to combine firms as a means to preserve the functioning of the financial system. The megabanks achieved too-big-to-fail status. While this should have meant they be treated as public utilities requiring heightened regulation and risk control, other deregulatory maneuvers (including repeal of Glass-Steagall) enabled these gigantic institutions to benefit from explicit and implicit federal guarantees, even as they pursued reckless high-risk investments. 12. Rampant Conflicts of Interest: Credit Ratings Firms Failure Credit ratings are a key link in the financial crisis story. With Wall Street combining mortgage loans into pools of securitized assets and then slicing them up into tranches, the resultant financial instruments were attractive to many buyers because they promised high returns. But pension funds and other investors could only enter the game if the securities were highly rated. The credit rating firms enabled these

20 20 SOLD OUT investors to enter the game, by attaching high ratings to securities that actually were high risk as subsequent events have revealed. The credit ratings firms have a bias to offering favorable ratings to new instruments because of their complex relationships with issuers, and their desire to maintain and obtain other business dealings with issuers. This institutional failure and conflict of interest might and should have been forestalled by the SEC, but the Credit Rating Agencies Reform Act of 2006 gave the SEC insufficient oversight authority. In fact, the SEC must give an approval rating to credit ratings agencies if they are adhering to their own standards even if the SEC knows those standards to be flawed. table. With Wall Street having destroyed the system that enriched its high flyers, and plunged the global economy into deep recession, it s time for Congress to tell Wall Street that its political investments have also gone bad. This time, legislating must be to control Wall Street, not further Wall Street s control. This report s conclusion offers guiding principles for a new financial regulatory architecture. Wall Street is presently humbled, but not prostrate. Despite siphoning trillions of dollars from the public purse, Wall Street executives continue to warn about the perils of restricting financial innovation even though it was these very innovations that led to the crisis. And they are scheming to use the coming Congressional focus on financial regulation to centralize authority with industry-friendly agencies. If we are to see the meaningful regulation we need, Congress must adopt the view that Wall Street has no legitimate seat at the

21 SOLD OUT 21 Part I: 12 Deregulatory Steps to Financial Meltdown

22 22 SOLD OUT 1 REPEAL OF THE GLASS- STEAGALL ACT AND THE RISE OF THE CULTURE OF RECKLESSNESS IN THIS SECTION: The Financial Services Modernization Act of 1999 formally repealed the Glass-Steagall Act of 1933 (also known as the Banking Act of 1933) and related laws, which prohibited commercial banks from offering investment banking and insurance services. In a form of corporate civil disobedience, Citibank and insurance giant Travelers Group merged in 1998 a move that was illegal at the time, but for which they were given a two-year forbearance on the assumption that they would be able to force a change in the relevant law at a future date. They did. The 1999 repeal of Glass-Steagall helped create the conditions in which banks invested monies from checking and savings accounts into creative financial instruments such as mortgage-backed securities and credit default swaps, investment gambles that rocked the financial markets in Perhaps the signature deregulatory move of the last quarter century was the repeal of the 1933 Glass-Steagall Act 4 and related legislation. 5 The repeal removed the legal prohibi- 4 Glass-Steagall repealed at Pub. L , title I, 101(a), Nov. 12, 1999, 113 Stat See amendments to the Bank Holding Company Act of 1956, 12 U.S.C , 1994 & Supp. II 1997 (amended 1999). tion on combinations between commercial banks on the one hand, and investment banks and other financial services companies on the other. Glass-Steagall s strict rules originated in the U.S. Government s response to the Depression and reflected the learned experience of the severe dangers to consumers and the overall financial system of permitting giant financial institutions to combine commercial banking with other financial operations. Glass-Steagall and related laws advanced the core public objectives of protecting depositors and avoiding excessive risk for the banking system by defining industry structure: banks could not maintain investment banking or insurance affiliates (nor affiliates in non-financial commercial activity). As banks eyed the higher profits in higher risk activity, however, they began to breach the regulatory walls between commercial banking and other financial services. Starting in the 1980s, responding to a steady drumbeat of requests, regulators began to weaken the strict prohibition on crossownership. In 1999, after a long industry campaign, Congress tore down the legal walls altogether. The Gramm-Leach-Bliley Act 6 removed the remaining legal restrictions on combined banking and financial service firms, and ushered in the current hyper-deregulated era. 6 Pub. L. No

23 SOLD OUT 23 The overwhelming direct damage inflicted by Glass-Steagall repeal was the infusion of investment banking culture into the conservative culture of commercial banking. After repeal, commercial banks sought high returns in risky ventures and exotic financial instruments, with disastrous results. Origins Banking involves the collection of funds from depositors with the promise that the funds will be available when the depositor wishes to withdraw them. Banks keep only a specified fraction of deposits in their vaults. They lend the rest out to borrowers or invest the deposits to generate income. Depositors depend on the bank s stability, and communities and businesses depend on banks to provide credit on reasonable terms. The difficulties faced by depositors in judging the quality of bank assets has required government regulation to protect the safety of depositors money and the well being of the banking system. In the 19th and early 20th centuries, the Supreme Court prohibited commercial banks from engaging directly in securities activities, 7 but bank affiliates subsidiaries of a 7 See California Bank v. Kennedy, 167 U.S. 362, (1897) (holding that national bank may neither purchase nor subscribe to stock of another corporation); Logan County Nat l Bank v. Townsend, 139 U.S. 67, 78 (1891) (holding that national bank may be liable as shareholder while in possession of bonds holding company that also owns banks were not subject to the prohibition. As a result, commercial bank affiliates regularly traded customer deposits in the stock market, often investing in highly speculative activities and dubious companies and derivatives. The Pecora Hearings The economic collapse that began with the 1929 stock market crash hit Americans hard. By the time the bottom arrived, in 1932, the Dow Jones Industrial Average was down 89 percent from its 1929 peak. 8 An estimated 15 million workers almost 25 percent 9 of the workforce were unemployed, real output in the United States fell nearly 30 percent and prices fell at a rate of nearly 10 percent per year. 10 obtained under contract made absent legal authority); National Bank v. Case, 99 U.S. 628, 633 (1878) (holding that national bank may be liable for stock held in another bank). 8 Floyd Norris, Looking Back at the Crash of 29, New York Times on the web, 1999, available at: <http://www.nytimes.com/library/financial/i ndex-1929-crash.html>. 9 Remarks by Federal Reserve Board Chairman Ben S. Bernanke, Money, Gold, and the Great Depression, March 2, 2004, available at: <http://www.federalreserve.gov/boarddocs/s peeches/2004/ /default.htm>. 10 Remarks by Federal Reserve Board Chairman Ben S. Bernanke, Money, Gold, and the Great Depression, March 2, 2004, available at: <http://www.federalreserve.gov/boarddocs/s peeches/2004/ /default.htm>.

24 24 SOLD OUT The Pecora Hearings, 11 held by the Senate Banking and Currency Committee and named after its chief counsel Ferdinand Pecora, investigated the causes of the 1929 crash. The committee uncovered blatant conflicts of interest and self-dealing by commercial banks and their investment affiliates. For example, commercial banks had misrepresented to their depositors the quality of securities that their investment banks were underwriting and promoting, leading the depositors to be overly confident in commercial banks stability. First National City Bank (now Citigroup) and its securities affiliate, the National City Company, had 2,000 brokers selling securities. 12 Those brokers had repackaged the bank s Latin American loans and sold them to investors as new securities (today, this is known as securitization ) without disclosing to customers the bank s confidential findings that the loans posed an adverse 11 The Pecora hearings, formally titled Stock Exchange Practices: Hearings Before the Senate Banking Committee, were authorized by S. Res. No. 84, 72d Cong., 1st Session (1931). The hearings were convened in the 72d and 73d Congresses ( ). 12 Federal Deposit Insurance Corporation website, The Roaring 20s, Undated, available at: <http://www.fdic.gov/about/learn/learning/ when/1920s.html>. The Pecora hearings concluded that common ownership of commercial banks and investment banks created several distinct problems. risk. 13 Peruvian government bonds were sold even though the bank s staff had internally warned that no further national loan can be safely made to Peru. The Senate committee found conflicts when commercial banks were able to garner confidential insider information about their corporate customers deposits and use it to benefit the bank s investment affiliates. In addition, commercial banks would routinely purchase the stock of firms that were customers of the bank, as opposed to firms that were most financially stable. The Pecora hearings concluded that common ownership of commercial banks and investment banks created several distinct problems, among them: 1) jeopardizing depositors by investing their funds in the stock market; 2) loss of the public s confidence in the banks, which led to panic withdrawals; 3) the making of unsound loans; and 4) an inability to provide honest investment advice to depositors because banks were conflicted by their underwriting relationship with companies Federal Deposit Insurance Corporation website, The Roaring 20s, Undated, available at: <http://www.fdic.gov/about/learn/learning/ when/1920s.html>. 14 Joan M. LeGraw and Stacey L. Davidson, Glass-Steagall and the Subtle Hazards of

25 SOLD OUT 25 Congress Acts The Glass-Steagall Act consisted of four provisions to address the conflicts of interest that the Congress concluded had helped trigger the 1929 crash: Section 16 restricted commercial national banks from engaging in most investment banking activities; 15 Section 21 prohibited investment banks from engaging in any commercial banking activities; 16 Section 20 prohibited any Federal Reserve-member bank from affiliating with an investment bank or other company engaged principally in securities trading; 17 and Judicial Activism, 24 New Eng. L. Rev. 225, Fall U.S.C. 24, Seventh (1933) (provided that a national bank shall not underwrite any issue of securities or stock ) U.S.C. 378(a) (1933) ( it shall be unlawful - (1) For any person, firm, corporation, association, business trust, or other similar organization, engaged in the business of issuing, underwriting, selling, or distributing, at wholesale or retail, or through syndicate participation, stocks, bonds, debentures, notes, or other securities, to engage at the same time to any extent whatever in the business of [deposit banking] U.S.C. 377 (1933) (prohibited affiliations between banks that are members of the Federal Reserve System and organizations engaged principally in the issue, flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stocks, bonds, debentures, notes, or other securities... ). Federal Reserve member banks include all national banks and some state-chartered banks and are subject to regulations of the Federal Reserve System, often referred to as the Section 32 prohibited individuals from serving simultaneously with a commercial bank and an investment bank as a director, officer, employee, or principal. 18 One exception in Section 20 permitted securities activities by banks in limited circumstances, such as the trading of municipal general obligation bonds, U.S. government bonds, and real estate bonds. It also permitted banks to help private companies issue commercial paper for the purpose of obtaining short-term loans. (Commercial paper is a debt instrument or bond equivalent to a short-term loan; companies issue commercial paper to fund daily (i.e., short-term) operations, including payments Federal Reserve or simply the Fed. The Fed, created in 1913, is the central bank of the United States comprised of a central, governmental agency the Board of Governors in Washington, D.C., and twelve regional Federal Reserve Banks, located in major cities throughout the nation. The Fed supervises thousands of its member banks and controls the total supply of money in the economy by establishing the rate of interest it charges banks to borrow. It is considered an independent central bank because its decisions do not have to be ratified by the President and Congress. Federal Reserve member banks must comply with the Fed's minimum capital requirements. (See The Structure of the Federal Reserve System, Federal Reserve, available at: <http://federalreserve.gov/pubs/frseries/frser i.htm>.) U.S.C. 78 (1933) (provided that no officer, director, or employee of a bank in the Federal Reserve System may serve at the same time as officer, director, or employee of an association primarily engaged in the activity described in section 20).

26 26 SOLD OUT to employees and financing inventories. panies became a popular way for financial Most commercial paper has a maturity of 30 institutions and other corporations to subvert days or less. Companies issue commercial the Glass-Steagall wall separating commercial and investment banking. In response, paper as an alternative to taking out a loan from a bank.) Congress enacted the Bank Holding Company Act of 1956 Glass-Steagall was a (BHCA) key element of the Roosevelt administration s response to the Depression and considered essential both to restoring public confidence in a financial system that had failed and to protecting the nation against another profound economic collapse. While the financial industry was cowed by the Depression, it did not fully embrace the New Glass-Steagall was a key element of the Roosevelt administration s response to the Depression and considered essential both to restoring public confidence in a financial system that had failed and to protecting the nation against another profound economic collapse. to prohibit bank holding companies from acquiring non-banks or engaging in activities that are not closely related to banking. Depository institutions were considered banks while investment banks (e.g. those that trade stock on Wall Street) were deemed nonbanks under the law. As with Glass-Steagall, Congress expressed its intent to separate customer deposits in banks from risky invest- Deal, and almost immediately sought to ments in securities. Importantly, the BHCA maneuver around Glass-Steagall. A legal also mandated the separation of banking construct known as a bank holding company was not subject to the Glass-Steagall cial activities. The BHCA also required from insurance and non-financial commer- restrictions. Under the Federal Reserve bank holding companies to divest all their System, bank holding companies are paper or shell companies whose sole pur- acquisition of banks across state lines. holdings in non-banking assets and forbade pose is to own two or more banks. Despite But the BHCA contained a loophole the prohibitions in Glass-Steagall, a single sought by the financial industry. It allowed company could own both commercial and bank holding companies to acquire nonbanks if the Fed determined that the non- investment banking interests if those interests were held as separate subsidiaries by a bank activities were closely related to bank holding company. Bank holding com- banking. The Fed was given wide latitude

27 SOLD OUT 27 under the Bank Holding Company Act to approve or deny such requests. In the decades that followed passage of the BHCA, the Federal Reserve frequently invoked its broad authority to approve bank holding company acquisitions of investment banking firms, thereby weakening the wall separating customer deposits from riskier trading activities. Deference to regulators In furtherance of the Fed s authority under BHCA, the Supreme Court in 1971 ruled that courts should defer to regulatory decisions involving bank holding company applications to acquire non-bank entities under the BHCA loophole. As long as a Federal Reserve Board interpretation of the BHCA is reasonable and expressly articulated, judges should not intervene, the court concluded. 19 The ruling was a victory for opponents of Glass Steagall because it increased the power of bank-friendly regulators. It substantially freed bank regulators to authorize bank holding companies to conduct new non-banking activities without judicial interference, 20 rendering a significant blow to Glass-Steagall. As a result, banks whose primary business was managing customer deposits and making loans began using their bank holding companies to 19 Investment Company Inst. v. Camp, 401 U.S. 617 (1971). 20 Jonathan Zubrow Cohen, 8 Admin. L.J. Am. U. 335, Summer buy securities firms. For example, Bank- America purchased stock brokerage firm Charles Schwab in The Federal Reserve had decided that Schwab s service of executing buy and sell stock orders for retail investors was closely related to banking and thus satisfied requirements of the BHCA. In December 1986, the Fed reinterpreted the phrase engaged principally, in Section 20 of the BHCA, which prohibited banks from affiliating with companies engaged principally in securities trading. The Fed decided that up to 5 percent of a bank s gross revenues could come from investment banking without running afoul of the ban. 22 Just a few months later, in the spring of 1987, the Fed entertained proposals from Citicorp, J.P Morgan and Bankers Trust to loosen Glass-Steagall regulations further by allowing banks to become involved with commercial paper, municipal revenue bonds and mortgage-backed securities. The Federal Reserve approved the proposals in a 3-2 vote. 23 One of the dissenters, then-chair Paul Volcker, was soon replaced by Alan 21 Securities Industry Association v. Federal Reserve System, 468 U.S. 207 (1984). 22 The Long Demise of Glass-Steagall, PBS Frontline, May 8, 2003, available at: <http://www.pbs.org/wgbh/pages/frontline/s hows/wallstreet/weill/demise.html>. 23 The Long Demise of Glass-Steagall, PBS Frontline, May 8, 2003, available at: <http://www.pbs.org/wgbh/pages/frontline/s hows/wallstreet/weill/demise.html>.

28 28 SOLD OUT Greenspan, a strong proponent of deregulation. In 1989, the Fed enlarged the BHCA loophole again, at the request of J.P. Morgan, Chase Manhattan, Bankers Trust and Citicorp, permitting banks to generate up to 10 percent of their revenue from investment banking activity. In 1993, the Fed approved an acquisition by a bank holding company, in this case Mellon Bank, of TBC Advisors, an administrator and advisor of stock mutual funds. By acquiring TBC, Mellon Bank was authorized to provide investment advisory services to mutual funds. By the early 1990s, the Fed had authorized commercial bank holding companies to own and operate full service brokerages and offer investment advisory services. Glass Steagall was withering at the hands of industry-friendly regulators whose free market ideology conflicted with the Depression-era reforms. The Financial Services Modernization Act While the Fed had been progressively undermining Glass-Steagall through deregulatory interpretations of existing laws, the financial industry was simultaneously lobbying Congress to repeal Glass-Steagall altogether. Members of Congress introduced major deregulation legislation in 1982, 1988, 1991, 1995 and Big banks, securities firms and insurance companies 24 spent lavishly in support of the legislation in the late 1990s. During the Congress, the three industries delivered more than $85 million in campaign contributions, including soft money donations to the Democratic and Republican parties. 25 But the Glass-Steagall rollback stalled. The Clinton administration was winding down, and the finance industries were becoming increasingly nervous that the legislation would not pass. In the next congressional session, the industry redoubled its efforts, upping campaign contributions to more than $ Bank holding companies were prohibited from providing insurance not under Glass- Steagall, but the Bank Holding Company Act of Section 4(c)(8) of the Bank Holding Company Act of 1956, as amended, prohibited bank holding companies and their subsidiaries from providing insurance as a principal, agent or broker except under seven minor exemptions. See 12 U.S.C (1994 & Supp. II 1997) (amended 1999). Under the Act, banks were permitted only to engage in activities that were deemed closely related to banking. The statutory definition of closely related to banking specifically excludes insurance activities. See Bank Holding Company Act 4(c)(8), 12 U.S.C. 1843(c)(8) (1994). From the time Glass-Steagall was enacted until the Bank Holding Company Act of 1956 was passed, bank holding companies had become increasingly involved in insurance (and securities) activities. The Bank Holding Company Act ended this activity. Gramm-Leach- Bliley ended the Bank Holding Company Act s prohibition in In this sense, references to Glass-Steagall, in this report, and in most policy discussions, commonly refer also to the BHCA of 1956, which is just as important as Glass-Steagall itself. 25 Data from the Center for Responsive Politics. <www.opensecrets.org>.

29 SOLD OUT 29 million, 26 in considerable part to support Glass-Steagall repeal, now marketed under a new and deceptive name, Financial Modernization. The Clinton administration supported the push for deregulation. Clinton s Treasury Secretary, Robert Rubin, who had run Goldman Sachs, enthusiastically promoted the legislation. In 1995 testimony before the House Banking Committee, for example, Rubin had argued that the banking industry is fundamentally different from what it was two decades ago, let alone in U.S. banks generally engage in a broader range of securities activities abroad than is permitted domestically. Even domestically, the separation of investment banking and commercial banking envisioned by Glass-Steagall has eroded significantly. Remarkably, he claimed that Glass-Steagall could conceivably impede safety and soundness by limiting revenue diversification. 27 At times, the Clinton administration even toyed with the idea of allowing a total blurring of the lines between banking and 26 Data from the Center for Responsive Politics. <www.opensecrets.org>. 27 Rubin Calls for Modernization Through Reform of Glass-Steagall Act, Journal of Accountancy, May 1, 1995, available at: <http://www.allbusiness.com/government/b usiness-regulations/ html>. The Clinton administration was winding down, and the finance industries were becoming increasingly nervous that the legislation to repeal Glass-Steagall would not pass. commerce (meaning non-financial businesses), but was forced to back away from such a radical move after criticism from former Federal Reserve Chair Paul Volcker and key Members of Congress. 28 Rubin played a key role in obtaining approval of legislation to repeal Glass-Steagall, as both Treasury Secretary and in his subsequent private sector role. A handful of other personalities were instrumental in the effort. Senator Phil Gramm, R- Texas, the truest of true believers in deregulation, was chair of the Senate Banking Committee, and drove the repeal legislation. He was assisted by Federal Reserve Chair Alan Greenspan, an avid proponent of deregulation who was also eager to support provisions of the proposed Financial Services Modernization Act that gave the Fed enhanced jurisdictional authority at the expense of other federal banking regulatory agencies. Notes Jake Lewis, formerly a professional staff member of the House Banking Committee, When the legislation became snagged on controversial provisions, 28 Jake Lewis, Monster Banks: The Political and Economic Costs of Banking and Financial Consolidation, Multinational Monitor, January/February 2005, available at: <http://www.multinationalmonitor.org/mm2 005/012005/lewis.html>.

30 30 SOLD OUT Greenspan would invariably draft a letter or present testimony supporting Gramm s position on the volatile points. It was a classic back-scratching deal that satisfied both players Greenspan got the dominant regulatory role and Gramm used Greenspan s wise words of support to mute opposition and to help assure a friendly press would grease passage. 29 Also playing a central role were the CEOs of Citicorp and Travelers Group. In 1998, the two companies announced they were merging. Such a combination of banking and insurance companies was illegal under the Bank Holding Company Act, but was excused due to a loophole in the BHCA which provided a two-year review period of proposed mergers. Travelers CEO Sandy Weill met with Greenspan prior to the announcement of the merger, and said Greenspan had a positive response to the audacious proposal. 30 Citigroup s co-chairs Sandy Weill and John Reed, along with lead lobbyist Roger Levy, led a swarm of industry executives 29 Jake Lewis, Monster Banks: The Political and Economic Costs of Banking and Financial Consolidation, Multinational Monitor, January/February 2005, available at: <http://www.multinationalmonitor.org/mm2 005/012005/lewis.html>. 30 Peter Pae, Bank, Insurance Giants Set Merger: Citicorp, Travelers in $82 Billion Deal, Washington Post, April 7, The Depression-era conflicts and consequences that Glass-Steagall was intended to prevent re-emerged once the Act was repealed. and lobbyists who badgered the administration and pounded the halls of Congress until the final details of a deal were hammered out. Top Citigroup officials vetted drafts of the legislation before they were formally introduced. 31 As the deal-making on the bill moved into its final phase in Fall 1999 and with fears running high that the entire exercise would collapse Robert Rubin stepped into the breach. Having recently resigned as Treasury Secretary, Rubin was at the time negotiating the terms of his next job as an executive at Citigroup. But this was not public knowledge at the time. Deploying the credibility built up as part of what the media had labeled The Committee to Save the World (Rubin, Greenspan and then-deputy Treasury Secretary Lawrence Summers, so named for their interventions in addressing the Asian financial crisis in 1997), Rubin helped broker the final deal. The Financial Services Modernization Act, also known as the Gramm-Leach-Bliley Act of 1999, formally repealed Glass- Steagall. The new law authorized banks, 31 Russell Mokhiber, The 10 Worst Corporations of 1999, Multinational Monitor, December 1999, available at: <http://www.multinationalmonitor.org/mm1 999/mm html>.

31 SOLD OUT 31 securities firms and insurance companies to combine under one corporate umbrella. A new clause was inserted into the Bank Holding Company Act allowing one entity to own a separate financial holding company that can conduct a variety of financial activities, regardless of the parent corporation s main functions. In the congressional debate over the Financial Services Modernization Act, Senator Gramm declared, Glass- Steagall, in the midst of the Great Depression, thought government was the answer. In this period of economic growth and prosperity, we believe freedom is the answer. The chief economist of the Office of the Comptroller of the Currency supported the legislation because of the increasingly persuasive evidence from academic studies of the pre- Glass-Steagall era. 32 Impact of Repeal The gradual evisceration of Glass-Steagall over 30 years, culminating in its repeal in 1999, opened the door for banks to enter the highly lucrative practice of packaging multiple home mortgage loans into securities for trade on Wall Street. Repeal of Glass-Steagall created a climate and culture 32 James R. Barth, R. Dan Brumbaugh Jr. and James A. Wilcox, The Repeal of Glass- Steagall and the Advent of Broad Banking, Economic and Policy Analysis Working Paper , Office of the Comptroller of the Currency, April 2000, available at: <http://www.occ.treas.gov/ftp/workpaper/w p pdf>. where aggressive deal-making became the norm. The practice of securitization had virtually disappeared after it contributed to the 1929 crash, but had made a comeback in the 1970s as Glass-Steagall was being dismantled. Economic analyst Robert Kuttner testified in 2007 that trading loans on Wall Street was the core technique that made possible the dangerous practices of the 1920s. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank e.g. Morgan or Chase as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act 33 that separated banks and securities trading. Whereas bank deposits had been a centerpiece of the 1929 crash, mortgage loans and the securities connected to them are at the center of the present financial crisis. There is mounting evidence that the repeal of Glass-Steagall contributed to a high-flying culture that led to disaster. The banks suspended careful scrutiny of loans they originated because they knew that the loans would be rapidly packaged into mort- 33 Testimony of Robert Kuttner before the Committee on Financial Services, U.S. House of Representatives, October 2, 2007, available at: <http://financialservices.house.gov/hearing1 10/testimony_-_kuttner.pdf>.

32 32 SOLD OUT gage-backed securities and sold off to third parties. Since the banks weren t going to hold the mortgages in their own portfolios, they had little incentive to review the borrowers qualifications carefully. 34 But the banks did not in fact escape exposure to the mortgage market. It appears that, as they packaged mortgages into securities and then sold them off into tranches, the banks often kept portions of the least desirable tranches in their own portfolios, or those of off-balance-sheet affiliates. They also seemed to have maintained liability in some cases where securitized mortgages went bad. As banks lost billions on mortgage-backed securities in 2008, they stopped making new loans in order to conserve their assets. Instead of issuing new loans with hundreds of billions of dollars in taxpayerfooted bailout money given for the purpose of jump-starting frozen credit markets, the banks used the money to offset losses on their mortgage securities investments. Banks and insurance companies were saddled with billions more in losses from esoteric credit default swaps created to insure against 34 See Liz Rappaport and Carrick Mollenkamp, Banks May Keep Skin in the Game, Wall Street Journal, February 9, 2009, available at: <http://sec.online.wsj.com/article/sb html>; Before That, They Made A Lot of Money: Steps to Financial Collapse, An Interview with Nomi Prins, Multinational Monitor, November/December 2008, available at: <http://www.multinationalmonitor.org/mm2 008/112008/interview-prins.html>. mortgage defaults and themselves traded on Wall Street. In short, the Depression-era conflicts and consequences that Glass-Steagall was intended to prevent re-emerged once the Act was repealed. The once staid commercial banking sector quickly evolved to emulate the risk-taking attitude and practices of investment banks, with disastrous results. Notes economist Joseph Stiglitz, The most important consequence of the repeal of Glass-Steagall was indirect it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be highrisk ventures; they are supposed to manage other people s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people s money people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investmentbank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risk taking Joseph Stiglitz, Capitalist Fools, Vanity Fair, January 2009, available at: <http://www.vanityfair.com/magazine/2009/ 01/stiglitz200901>.

33 SOLD OUT 33 2 HIDING LIABILITIES: OFF-BALANCE SHEET ACCOUNTING IN THIS SECTION: Holding assets off the balance sheet generally allows companies to exclude toxic or money-losing assets from financial disclosures to investors in order to make the company appear more valuable than it is. Banks used off-balance sheet operations special purpose entities (SPEs), or special purpose vehicles (SPVs) to hold securitized mortgages. Because the securitized mortgages were held by an off-balance sheet entity, however, the banks did not have to hold capital reserves as against the risk of default thus leaving them so vulnerable. Off-balance sheet operations are permitted by Financial Accounting Standards Board rules installed at the urging of big banks. The Securities Industry and Financial Markets Association and the American Securitization Forum are among the lobby interests now blocking efforts to get this rule reformed. financial health is illusory. Thanks to the exploitation of loopholes in accounting rules, commercial banks were able to undertake exactly this sort of deceptive financial shuffling in recent years. Even in good times, placing securitized mortgage loans off balance sheet had important advantages for banks, enabling them to expand lending without setting aside more reserve-loss capital (money set aside to protect against loans that might not be repaid). 36 As they made and securitized more loans shunted off into off-balance sheet entities, the banks financial vulnerability kept increasing they had increased lingering obligations related to securitized loans, without commensurate reserve-loss capital. Then, when bad times hit, off-balance sheet accounting let banks hide their losses from investors and regulators. This allowed their condition to grow still more acute, ultimately imposing massive losses on investors and threatening the viability of the financial system. A business s balance sheet is supposed to report honestly on a firm s financial state by listing its assets and liabilities. If a company can move money-losing assets off of its balance sheet, it will appear to be in greater financial health. But if it is still incurring losses from the asset taken off the balance sheet, then the apparent improvement in 36 Wall Street recognized this immediately after the adoption of the relevant accounting rule, known as FASB 140 (see text below for more explanation). How the sponsors and their lawyers and accountants address FASB 140 may have an impact on the continuing viability of this market, said Gail Sussman, a managing director at Moody's. If they have to keep these bonds on their balance sheet, they have to reserve against them. It may eat into the profit of these products [securitized loans]. Michael McDonald, Derivatives Hit the Wall - Sector Found Wary Investors in 2001, The Bond Buyer, March 15, 2002.

34 34 SOLD OUT The scale of banks off-balance sheet assets is enormous 15.9 times the amount on the balance sheets in This ratio represents a massive surge over the last decade and half: During the period , on-balance sheet assets grew by 200 percent, while off-balance sheet asset grew by a whopping 1,518 [percent]. 37 One Wall Street executive described off-balance sheet accounting as a bit of a magic trick 38 because losses disappear from the balance sheet, making lenders appear more financially stable than they really are. A former SEC official called it nothing more than just a scam. 39 The Securities and Exchange Commission (SEC) has statutory authority to establish financial accounting and reporting standards, but it delegates this 37 Joseph Mason, Off-balance Sheet Accounting and Monetary Policy Ineffectiveness, RGE Monitor, December 17, 2008, available at: <http://www.rgemonitor.com/financemarket s-monitor/254797/offbalance_sheet_accounting_and_monetary_p olicy_ineffectiveness>. 38 Alan Katz and Ian Katz, Greenspan Slept as Off-Books Debt Escaped Scrutiny, Bloomberg.com, October 30, 2008, available at: <http://www.bloomberg.com/apps/news?pid = &refer=home&sid=aYJZOB_gZi 0I> (quoting Pauline Wallace, partner at PriceWaterhouseCoopers LLP and team leader in London for financial instruments). 39 Plunge: How Banks Aim to Obscure Their Losses, An Interview with Lynn Turner, former SEC chief accountant, Multinational Monitor, November/December 2008, available at: <http://www.multinationalmonitor.org/mm2 008/112008/interview-turner.html>. authority to the Financial Accounting Standards Board (FASB). The FASB is an independent, private sector organization whose purpose is to establish financial accounting standards, including the standards that govern the preparation of financial reports. FASB s Statement 140 establishes rules relevant to securitization of loans (packaging large numbers of loans resold to other parties) and how securitized loans may be moved off a company s balance sheet. Pursuant to Statement 140, a lender may sell blocks of its mortgages to separate trusts or companies known as Qualified Special Purpose Entities (QSPEs), or special investment vehicles (SIVs), created by the lender. As long as the mortgages are sold to the QSPE, the lender is authorized not to report the mortgages on its balance sheet. The theory is that the lender no longer has control or responsibility for the mortgages. The Statement 140 test of whether a lender has severed responsibility for mortgages is to ask whether a true sale has taken place. But whether a true sale of the mortgages has occurred is often unclear because of the complexities of mortgage securitization. Lenders often retain some control over the mortgages even after their sale to a QSPE. So, while the sale results in moving mortgages off the balance sheet, the lender may still be liable for mortgage

35 SOLD OUT 35 defaults. This retained liability is concealed from the public by virtue of moving the assets off the balance sheet. Under Statement 140, a sale of mortgages to a QSPE occurs when the mortgages are put beyond the reach of the transferor [i.e. the lender] and its creditors. This is a true sale because the lender relinquishes control of the mortgages to the QSPE. But the current financial crisis has revealed that while lenders claimed to have relinquished control, and thus moved the mortgages off the balance sheet, they had actually retained control in violation of Statement 140. A considerable portion of the banks mortgage-related losses remain off the books, however, contributing to the continuing uncertainty about the scale of the banks losses. The problems with QSPEs became clear in 2007 when homeowners defaulted in record numbers and lenders were forced to renegotiate or modify mortgages held in the QSPEs. The defaults revealed that the mortgages were not actually put beyond the reach of the lender after the QSPE bought them. As such, they should have been included on the lender s balance sheet pursuant to Statement 140. The Securities and Exchange Commission (SEC) was forced to clarify its rules on A former SEC official called off-balance sheet accounting nothing more than just a scam. the matter to allow lenders to renegotiate loans without losing off-balance sheet status. Statement Former SEC Chair Christopher Cox announced to Congress in 2007 that loan restructuring or modification activities, when default is reasonably foreseeable, does not preclude continued off-balance sheet treatment under The problems with off-balance sheet accounting are a matter of common sense. If there was any doubt, however, the deleterious impact of off-balance sheet accounting was vividly illustrated by the notorious collapse of Enron in December Enron established off-balance sheet partnerships whose purpose was to borrow from banks to finance the company s growth. The partnerships, also known as special purpose entities (SPEs), borrowed heavily by using Enron stock as collateral. The debt incurred by the SPEs was kept off Enron s balance sheet so that Wall Street 40 (Chairman Christopher Cox, in a letter to Rep. Barney Frank, Chairman, Committee on Financial Services, U.S. House of Representatives, July 24, 2007, available at: <http://www.house.gov/apps/list/press/finan cialsvcs_dem/sec_response pdf>.) The SEC's Office of the Chief Accountant agreed with Chairman Cox in a staff letter to industry in (SEC Office of the Chief Accountant, in a staff letter to Arnold Hanish, Financial Executives International, January 8, 2008, available at: <http://www.sec.gov/info/accountants/staffl etters/hanish pdf>).

36 36 SOLD OUT and regulators were unaware of it. Credit rating firms consistently gave Enron high debt ratings as they were unaware of the institutions, setting the stage for the current financial crisis. The Enron fiasco got the attention of enormous off-balance sheet liabilities. Congress, which soon began considering Investors pushing Enron s stock price to systemic accounting reforms. The Sarbanessky-high levels were Oxley Act, passed in 2002, oblivious to the enormous amount of debt incurred to finance the company s growth. The skyrocketing stock price allowed Enron to borrow even more funds while using its own stock as collateral. At the time of bankruptcy, the company s on-balance sheet debt was $13.15 billion, but the The Sarbanes-Oxley Act, passed in 2002, attempted to shine more light on the murky underworld of offbalance sheet assets, but the final measure was a watered-down compromise. attempted to shine more light on the murky underworld of off-balance sheet assets, but the final measure was a watereddown compromise; more far-reaching demands were defeated by the financial lobby. Sarbanes-Oxley requires that companies make some company had a roughly equal amount of offbalance sheet liabilities. In the fallout of the Enron scandal, the FASB adopted a policy to address offbalance sheet arrangements. Under its FIN 46R guidance, a company must include any disclosures about their QSPEs, even if they are not required to include them on the balance sheet. Specifically, it requires disclosure of the existence of off-balancesheet arrangements, including QSPEs, if they are reasonably likely to have a SPE on the balance sheet if the company is material impact on the company s entitled to the majority of the SPE s risks or rewards, regardless of whether a true sale financial condition. But lenders have sole discretion to determine whether a QSPE will occurred. But the guidance has one caveat: have a material impact. Moreover, QSPEs holding securitized assets may still be excluded from the balance sheet. The caveat, known as the scope exception, means that many financial institutions are not subject to the heightened requirements provided under FIN 46R. The lessons of Enron were thus ignored for financial disclosures have often been made in such a general way as to be meaningless. After Enron, with Sarbanes-Oxley, we tried legislatively to make it clear that there has to be some transparency with regard to offbalance sheet entities, Senator Jack Reed of Rhode Island, the chair of the Securities,

37 SOLD OUT 37 Insurance and Investment subcommittee of the Senate Banking Committee, said in early 2008 as the financial crisis was unfolding. 41 We thought that was already corrected and the rules were clear and we would not be discovering new things every day, he said. The FASB has recognized for years that Statement 140 is flawed, concluding in 2006 that the rule was irretrievably broken. 42 The merits of the true sale theory of Statement 140 notwithstanding, its detailed and complicated rules created sufficient loopholes and exceptions to enable financial institutions to circumvent its purported logic as a matter of course. 43 FASB Chairman Robert Herz likened off-balance sheet accounting to spiking the punch bowl. Unfortunately, he said, it seems that some folks used [QSPEs] like a punch bowl to get off-balance sheet treatment while spiking the punch. That has led us to conclude that now it s time to take away the punch bowl. And so we are proposing eliminating the concept of a 41 Floyd Norris, Off-the-balance-sheet mysteries, International Herald Tribune, February. 28, 2008, available at: <http://www.iht.com/articles/2008/02/28/bu siness/norris29.php>. 42 FASB and International Accounting Standards Board, Information for Observers, April 21, 2008, available at: <www.iasplus.com/resource/0804j03obs.pdf >. 43 See Thomas Selling, FAS 140: Let s Call the Whole Thing Off, August 11, 2008, available at: <http://accountingonion.typepad.com/theacc ountingonion/2008/08/fas-140-letsca.html>. QSPE from the U.S. accounting literature. 44 It is not, however, a certainty that the FASB will succeed in its effort. The Board has repeatedly tried to rein in off-balance sheet accounting, but failed in the face of financial industry pressure. 45 The commercial banking industry and Wall Street are waging a major effort to water down the rule and delay adoption and implementation. 46 Ironically, the banking 44 FASB Chairman Bob Herz, Lessons Learned, Relearned, and Relearned Again from the Credit Crisis Accounting and Beyond, September 18, 2008, available at: <http://www.fasb.org/articles&reports/ _herz_speech.pdf>. 45 Plunge: How Banks Aim to Obscure Their Losses, An Interview with Lynn Turner, former SEC chief accountant, Multinational Monitor, November/December 2008, available at: <http://www.multinationalmonitor.org/mm2 008/112008/interview-turner.html>. 46 See FAS Amendments, American Securitization Forum, available at: <http://www.americansecuritization.com/sto ry.aspx?id=76>. ( Throughout this process [consideration of revisions of Statement 140], representatives of the ASF have met on numerous occasions with FASB board members and staff, as well as accounting staff of the SEC and the bank regulatory agencies, to present industry views and recommendations concerning these proposed accounting standards and their impact on securitization market activities. ); George P. Miller, Executive Director, American Securitization Forum, and Randy Snook, Senior Managing Director, Securities Industry and Financial Markets Association, letter to Financial Accounting Standards Board, July 16, 2008, available at: <http://www.americansecuritization.com/sto ry.aspx?id=2906>. (Arguing for delay of new rules until 2010, and contending that It is also important to remember that too much consolidation of SPEs can be just as confusing to users of financial statements as

38 38 SOLD OUT industry and Wall Street lobbyists argue that disclosure of too much information will confuse investors. These lobby efforts are meeting with success, 47 in part because of the likelihood that forcing banks to recognize their off-balance sheet losses will reveal them to be insolvent. too little. ); John A. Courson, Chief Operating Officer, Mortgage Bankers Association, letter to Financial Accounting Standards Board, October 31, 2008, available at: <http://www.mbaa.org/files/advocacy/testi monyandcommentletters/mbacommentle tter AmendmentstoFASBInterpretationNo.46R.p df>. ( MBA believes the proposed disclosures would result in providing readers of financial statements with an unnecessary volume of data that would obfuscate important and meaningful information in the financial statements. ) 47 Jody Shenn and Ian Katz, FASB Postpones Off-Balance-Sheet Rule for a Year, Bloomberg, July 30, 2008, available at: <http://www.bloomberg.com/apps/news?pid = &sid=a4O4VjK.fX5Q&>. ( The Financial Accounting Standards Board postponed a measure, opposed by Citigroup Inc. and the securities industry, forcing banks to bring off-balance-sheet assets such as mortgages and credit-card receivables back onto their books. FASB, the Norwalk, Connecticut-based panel that sets U.S. accounting standards, voted 5-0 today to delay the rule change until fiscal years starting after Nov. 15, )

39 SOLD OUT 39 3 THE EXECUTIVE BRANCH REJECTS FINANCIAL DERIVATIVE REGULATION IN THIS SECTION: Financial derivatives are unregulated. By all accounts this has been a disaster, as Warren Buffet s warning that they represent weapons of mass financial destruction has proven prescient. Financial derivatives have amplified the financial crisis far beyond the unavoidable troubles connected to the popping of the housing bubble. The Commodity Futures Trading Commission (CFTC) has jurisdiction over futures, options and other derivatives connected to commodities. During the Clinton administration, the CFTC sought to exert regulatory control over financial derivatives. The agency was quashed by opposition from Treasury Secretary Robert Rubin and, above all, Fed Chair Alan Greenspan. They challenged the agency s jurisdictional authority; and insisted that CFTC regulation might imperil existing financial activity that was already at considerable scale (though nowhere near present levels). Then-Deputy Treasury Secretary Lawrence Summers told Congress that CFTC proposals cas[t] a shadow of regulatory uncertainty over an otherwise thriving market. Over-the-counter financial derivatives are unregulated. By all accounts, this has been a disaster. As Warren Buffett warned in 2003, financial derivatives represent weapons of mass financial destruction because [l]arge amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers so that [t]he troubles of one could quickly infect the others and trigger serious systemic problems. 48 A financial derivative is a financial instrument whose value is determined by the value of an underlying financial asset, such as a mortgage contract, stock or bond, or by financial conditions, such as interest rates or currency values. The value of the contract is determined by fluctuations in the price of the underlying asset. Most derivatives are characterized by high leverage, meaning they are bought with enormous amounts of borrowed money. Derivatives are not a recent invention. 48 Warren Buffett, Chairman, Berkshire Hathaway, Report to Shareholders, February 21, Wrote Buffet: Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown. Available at: <http://www.berkshirehathaway.com/letters/ 2002pdf.pdf>.

40 40 SOLD OUT Traditional, non-financial derivatives include futures contracts traded on exchanges such as the Chicago Mercantile Exchange, and regulated by the Commodity Futures Trading Commission. A traditional futures contract might include, for example, futures on oranges, where buyers and sellers agree to deliver or accept delivery of a specified number of oranges at some point in the future, at a price determined now, irrespective of the price for oranges at that future time. This kind of futures contract can help farmers and others gain some price certainty for commodities whose value fluctuates in uncertain ways. Over-the-counter (OTC) financial derivatives, by contrast, are negotiated and traded privately (not on public exchanges) and are not subjected to public disclosure, government supervision or other requirements applicable to those traded on exchanges. Derivatives and the current financial crisis In the 1990s, the financial industry began to develop increasingly esoteric types of derivatives. One over-the-counter derivative that has exacerbated the current financial crisis is the credit default swap (CDS). CDSs were invented by major banks in the mid-1990s as a way to insure against possible default by debtors (including mortgage holders). Investment banks that hold mortgage debt, including mortgage-backed securities, can purchase a CDS from a seller, such as an insurance company like AIG, which agrees to become liable for all the debt in the event of a default in the mortgage-backed securities. Wall Street wunderkinds with backgrounds in complex mathematics and statistics developed algorithms that they claimed allowed them to correctly price the risk and the CDSs. 49 Banks and hedge funds also began to sell CDSs and even trade them on Wall Street. Billions in these insurance policies were traded every day, with traders essentially betting on the likelihood of default on mortgage-backed securities. CDS traders with no financial interest in the underlying mortgages received enormous profits from buying and selling CDS contracts and thus speculating on the likelihood of default. The current financial crisis has exposed how poorly the sellers and the buyers understood the value of the derivatives they were trading. Once home values stopped rising in 2006 and mortgage default became more commonplace, the value of the packages of mortgages known as mortgage-backed securities plunged. At that point, the CDS agreements called for the sellers of the CDSs to reimburse the purchasers for the losses in the mortgage-backed securities. 49 Lewis Braham, Credit Default Swaps: Is Your Fund at Risk? BusinessWeek, February 21, 2008, available at: <http://www.businessweek.com/magazine/c ontent/08_09/b htm>.

41 SOLD OUT 41 Firms that had sold CDS contracts, like AIG, became responsible for posting billions of dollars in collateral or paying the purchasers. The global market value of CDS contracts ( notional value ) reached over $60 trillion in 2007, surpassing the gross domestic product of every country in the world combined. The value of the entire global derivatives market reached $683 trillion by mid- 2008, more than 20 times the total value of the U.S. stock market. 50 The total dollars actively at risk from CDSs is a staggering $3.1 trillion. 51 The amount at risk is far less than $60 trillion because most investors were simultaneously on both sides of the CDS trade. For example, banks and hedge funds would buy CDS protection on the one hand and then sell CDS protection on the same security to someone else at the same time. 52 When a mortgage-backed security defaulted, the 50 Bureau of International Settlements, Table 19: Amounts Outstanding of Over-the-counter Derivatives, available at: <www.bis.org/statistics/derstats.htm>. 51 Bureau of International Settlements, Table 19: Amounts Outstanding of Over-the-counter Derivatives, available at: <www.bis.org/statistics/derstats.htm>. 52 Adam Davidson, How AIG fell apart, Reuters, September 18, 2008, available at: <http://www.reuters.com/article/newsone/id USMAR >. The value of the entire global derivatives market reached $683 trillion by mid-2008, more than 20 times the total value of the U.S. stock market. banks might have to pay some money out, but they would also be getting money back in. So, while the total value of each CDS buy and sell order equaled $60 trillion in 2007, the actual value at risk was a fraction of that but still large enough to rock the financial markets. The insurance giant AIG, however, did not buy CDS contracts it only sold them. AIG issued $440 billion 53 worth of such contracts, making it liable for loan defaults, including billions in mortgage-backed securities that went bad after the housing bubble burst. In addition, the company s debt rating was downgraded by credit rating firms, a move that triggered a clause in its CDS contracts that required AIG to put up more collateral to guarantee its ability to pay. Eventually, AIG was unable to provide enough collateral or pay its obligations from the CDS contracts. Its stock price tumbled, making it impossible for the firm to attract investors. Many banks throughout the world were at risk because they had bought CDS contracts from AIG. The financial spiral downward ultimately required a taxpayerfinanced bailout by the Federal Reserve, which committed $152.5 billion to the com- 53 Adam Davidson, How AIG fell apart, Reuters, September 18, 2008, available at: <http://www.reuters.com/article/newsone/id USMAR >.

42 42 SOLD OUT pany in 2008, in order to minimize disruption to the financial markets. 54 Federal Agencies Reject Regulation of Financial Derivatives. Some industry observers warned of the dangers of over-the-counter derivatives. But acceding to political pressure from the powerful financial industry, the federal agencies with the responsibility to safeguard the integrity of the financial system refused to permit regulation of financial derivatives, 55 especially the credit default swaps that have exacerbated the current financial meltdown. In 1996, President Clinton appointed Brooksley Born chair of the Commodity Futures Trading Commission (CFTC). 56 The CFTC is an independent federal agency with the mandate to regulate commodity futures and option markets in the United States. Born was outspoken and adamant about the need to regulate the quickly growing but largely opaque area of financial derivatives. She found fierce opposition in SEC Chair 54 Erik Holm, AIG Sells Mortgage-Backed Securities to Fed Vehicle, Bloomberg.com, December 15, Exchange-traded and agricultural derivatives are generally regulated by the Commodity Futures Trading Commission (CFTC). Overthe-counter financial derivatives not traded on an exchange were and are not subject to CFTC jurisdiction. This report primarily uses the shorthand term financial derivative to reference over-the-counter financial derivatives. 56 <http://www.cftc.gov/anr/anrcomm98.htm> Arthur Levitt, Treasury Secretary Robert Rubin and Federal Reserve Chair Alan Greenspan, all of whom felt that the financial industry was capable of regulating itself. An April 1998 meeting of the President s Working Group on Financial Markets, which consisted of Levitt, Greenspan, Rubin and Born, turned into a standoff between the three men and Born. The men were determined to derail her efforts to regulate derivatives, but left the meeting without any assurances. 57 Pressing back against her critics, Born published a CFTC concept paper in 1998 describing how the derivatives sector might be regulated. Born framed the CFTC s interest in mild terms: The substantial changes in the OTC derivatives market over the past few years require the Commission to review its regulations, said Born. The Commission is not entering into this process with preconceived results in mind. We are reaching out to learn the views of the public, the industry and our fellow regulators on the appropriate regulatory approach to today s OTC derivatives marketplace Anthony Faiola, Ellen Nakashima and Jill Drew, The Crash: What Went Wrong, The Washington Post, October 15, 2008, available at: <http://www.washingtonpost.com/wpdyn/content/story/2008/10/14/st html>. 58 CFTC Issues Concept Release Concerning Over-the-Counter Derivatives Market, May 7, 1998, available at: <http://www.cftc.gov/opa/press98/opa htm>.

43 SOLD OUT 43 The publication described the growth of derivatives trading ( Use of OTC derivatives has grown at very substantial rates over the past few years, to a notional value of more than $28 trillion) and raised questions about financial derivatives rather than proposed specific regulatory initiatives. But the concept paper was clear that the CFTC view was that the unrestrained growth of financial derivatives trading posed serious risks to the financial system, and its probing questions suggested a range of meaningful regulatory measures measures which, if they had been adopted, likely would have reduced the severity of the present crisis. While OTC derivatives serve important economic functions, these products, like any complex financial instrument, can present significant risks if misused or misunderstood by market participants, the CFTC noted. 59 The explosive growth in the OTC market in recent years has been accompanied by an increase in the number and size of losses even among large and sophisticated users which purport to be trying to hedge price risk in the underlying cash markets Commodity Futures Trading Commission, Concept Release: Over-the-Counter Derivatives, May 7, 1998, available at: <http://www.cftc.gov/opa/press98/opamntn. htm#issues_for_comment>. 60 Commodity Futures Trading Commission, Concept Release: Over-the-Counter Derivatives, May 7, 1998, available at: <http://www.cftc.gov/opa/press98/opamntn. htm#issues_for_comment>. Among the proposals floated in the concept paper were the following measures: 61 Narrow or eliminate exemptions for financial derivatives from the regulations that applied to exchangetraded derivatives (such as for agricultural commodities); Require financial derivatives to be traded over a regulated exchange; Require registration of person or entities trading financial derivatives; Impose capital requirements on those engaging in financial derivatives trading (so that they would be required to set aside capital against the risk of loss, and to avoid excessive use of borrowed money); and Require issuers of derivatives to disclose the risks accompanying those instruments. The uproar from the financial industry was immediate. During the next two months, industry lobbyists met with CFTC commissioners at least 13 times. 62 Meanwhile, Born faced off against Greenspan and others in 61 Commodity Futures Trading Commission, Concept Release: Over-the-Counter Derivatives, May 7, 1998, available at: <http://www.cftc.gov/opa/press98/opamntn. htm#issues_for_comment>. 62 Sharona Coutts and Jake Bernstein, Former Clinton Official Says Democrats, Obama Advisers Share Blame for Market Meltdown, ProPublica, October 9, 2008, available at: <http://www.propublica.org/feature/formerclinton-official-says-democrats-obamaadvisers-share-blame-for-marke/>.

44 44 SOLD OUT numerous antagonistic congressional hearings. Senator Richard Lugar, R-Indiana, chair of the Senate Agricultural Committee, stepped into the fray. Lugar, who received nearly $250,000 in campaign contributions from securities and investment firms in 1998, 63 extended an ultimatum to Born: cease the campaign or Congress would pass a Treasury-backed bill that would put a moratorium on any further CFTC action. 64 The stalemate continued. The Treasury Department weighed in with its view that derivatives should remain unregulated. President Clinton s then-deputy Treasury Secretary, Lawrence H. Summers (now head of the Obama administration s National Economic Council), complained that Born s proposal cast the shadow of regulatory uncertainty over an otherwise 63 Center for Responsive Politics, <http://www.opensecrets.org/politicians/ind ustries.php?cycle=1998&cid=n >. 64 Senator Richard Lugar, Regulation of Over the Counter (OTC) Derivatives and Derivatives Markets, Hearing of the Senate Agriculture, Nutrition and Forestry Committee, July 30, 1998 ( [I]t is essential that the government not create legal uncertainty for swaps. I hope it will not be necessary, but there are circumstances that could compel Congress to act preemptively in the near term. ) For a full account of the dispute, see: <http://www.washingtonpost.com/wpdyn/content/story/2008/10/14/st html>. Lawrence Summers complained that a proposal to thriving market 65 regulate derivatives cast a shadow of regulatory uncertainty over an otherwise thriving market. Federal Reserve Chair Alan Greenspan echoed the Treasury Department view, arguing that regulation would be both unnecessary and harmful. Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary. Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living. 66 In September 1998, Long Term Capital Management, a hedge fund heavily focused on derivatives, informed the Fed it was on the brink of collapse, and couldn t cover $4 billion in losses. 67 The New York Federal Reserve quickly recruited 14 private banks to bail out Long Term Capital by investing $3.6 billion Lawrence H. Summers, Testimony Before the Senate Committee on Agriculture, Nutrition, and Forestry, July 30, 1998, available at: <http://www.ustreas.gov/press/releases/rr26 16.htm>. 66 Alan Greenspan, Regulation of Over the Counter (OTC) Derivatives and Derivatives Markets, Hearing of the Senate Agriculture, Nutrition and Forestry Committee, July 30, Anthony Faiola, Ellen Nakashima and Jill Drew, The Crash: What Went Wrong, The Washington Post, October 15, 2008, available at: <http://www.washingtonpost.com/wpdyn/content/story/2008/10/14/st html>. 68 Sharona Coutts and Jake Bernstein, Former

45 SOLD OUT 45 This episode should serve as a wake-up call about the unknown risks that the overthe-counter derivatives market may pose to the U.S. economy and to financial stability around the world, Born told the House Banking Committee two days later. It has highlighted an immediate and pressing need to address whether there are unacceptable regulatory gaps relating to hedge funds and other large OTC derivatives market participants. 69 But what should have been a moment of vindication for Born was swept aside by her adversaries, and Congress enacted a six-month moratorium on any CFTC action regarding derivatives or the swaps market. 70 (Permanent congressional action would soon follow, as the next section details.) In May 1999, Born resigned in frustration. Born s replacement, William Rainer, went along with Greenspan, Summers Clinton Official Says Democrats, Obama Advisers Share Blame for Market Meltdown, ProPublica, October 9, 2008, available at: <http://www.propublica.org/feature/formerclinton-official-says-democrats-obamaadvisers-share-blame-for-marke/>. 69 Brooksley Born, CFTC Chair, Testimony Before the House Committee on Banking and Financial Services, October 1, 1998, available at: <http://financialservices.house.gov/banking/ 10198bor.pdf>. 70 Anthony Faiola, Ellen Nakashima and Jill Drew, The Crash: What Went Wrong, The Washington Post, October 15, 2008, available at: <http://www.washingtonpost.com/wpdyn/content/story/2008/10/14/st html>. (whom Clinton had appointed Treasury Secretary) and Levitt s campaign to block any CFTC regulation. In November 1999, the inter-agency President s Working Group on Financial Markets released a new report on derivatives recommending no regulation, saying it would perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States. 71 Among other rationalizations for this nonregulatory posture, the report argued, the sophisticated counterparties that use OTC derivatives simply do not require the same protections as retail investors. 72 The report briefly touched upon, but did not take seriously, the idea that financial derivatives posed overall financial systemic risk. To the extent that such risk exists, the report concluded, it was well addressed by private parties: private counterparty discipline currently is the primary mechanism relied upon for achieving the public policy objective of reducing systemic risk. Government regulation should serve to supplement, rather than substitute for, private market 71 The President s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act, November 1999, available at: <http://www.treas.gov/press/releases/reports /otcact.pdf>. 72 The President s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act, November 1999, available at: <http://www.treas.gov/press/releases/reports /otcact.pdf>.

46 46 SOLD OUT discipline. In general, private counterparty credit risk management has been employed effectively by both regulated and unregulated dealers of OTC derivatives, and the tools required by federal regulators already exist The President s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act, November 1999, available at: <http://www.treas.gov/press/releases/reports /otcact.pdf>.

47 SOLD OUT 47 4 CONGRESS BLOCKS FINANCIAL DERIVATIVE REGULATION IN THIS SECTION: The deregulation or non-regulation of financial derivatives was sealed in 2000, with the Commodities Futures Modernization Act (CFMA), passage of which was engineered by then-senator Phil Gramm, R- Texas. The Commodities Futures Modernization Act exempts financial derivatives, including credit default swaps, from regulation and helped create the current financial crisis. Long before financial derivatives became the darlings of Wall Street, there were some in Congress who believed that the federal government should be given greater power to regulate derivatives. In 1994, Senator Donald Riegle, D- Michigan, and Representative Henry Gonzalez, D-Texas, introduced separate bills calling for derivatives regulation; 74 both went nowhere. 75 Opposing regulation was a 74 The Derivatives Supervision Act of 1994, in the Senate; the Derivatives Safety and Soundness Supervision Act of 1994, in the House. 75 Anthony Faiola, Ellen Nakashima and Jill Drew, The Crash: What Went Wrong, The Washington Post, October 15, 2008, available at: <http://www.washingtonpost.com/wpdyn/content/story/2008/10/14/st html>. bipartisan affair and inaction ruled the day. 76 In 2000, a year after the outspoken Brooksley Born left the Commodity Futures Trading Commission (CFTC), Congress and President Clinton codified regulatory inaction with passage of the Commodity Futures Modernization Act (CFMA). 77 The legislation included an Enron loophole, which prohibited regulation of energy futures contracts and thereby contributed to the collapse of scandal-ridden Enron in CFMA formally exempted financial derivatives, including the now infamous credit default swaps, from regulation and federal government oversight. One Wall Street analyst later noted that the CFMA was slipped into the [budget] bill in the dead of night by our old friend Senator Phil Gramm of Texas now Vice Chairman of [Swiss investment bank] UBS. 78 Gramm led the congressional effort to block federal agencies from regulating derivatives, complaining that [b]anks are already heavily regulated institutions. 79 Gramm predicted 76 The action that Congress did take the sixmonth moratorium on CFTC regulation described in the previous section cut against the need for regulation. 77 Pub. L. No , Appendix E, amending the Commodity Exchange Act, 7 U.S.C. 1 et. seq. 78 Dirk van Dijk, Credit Default Swaps Explained, Zacks Investment Research, September 24, 2008, available at: <http://www.zacks.com/stock/news/14884/ Credit+Default+Swaps+Explained>. 79 Sen. Phil Gramm, 106th Congress, 2nd Session, 146 Cong. Rec. S , December 15, 2000, available at:

48 48 SOLD OUT CFMA will be noted as a major achievement and as a watershed, where we turned away from the outmoded, Depression-era approach to financial regulation. 80 He said the legislation protects financial institutions from over-regulation, and provides legal certainty for the $60 trillion market in swaps 81 in other words, it offered a guarantee that they would not be regulated. By 2008, Gramm s UBS was reeling from the global financial crisis he had helped create. The firm declared nearly $50 billion in credit losses and write-downs, prompting a $60 billion bailout by the Swiss government. 82 Senator Gramm remains defiant today, telling the New York Times, There is this idea afloat that if you had more regulation you would have fewer mistakes. I don t see any evidence in our history or anybody <http://frwebgate.access.gpo.gov/cgibin/getpage.cgi?position=all&page=s11867 &dbname=2000_record>. 80 Sen. Phil Gramm, 106th Congress, 2nd Session, 146 Cong. Rec. S , December 15, 2000, available at: <http://frwebgate.access.gpo.gov/cgibin/getpage.cgi?position=all&page=s11868 &dbname=2000_record> th Congress, 2nd Session, 146 Cong. Rec. S , Dec. 15, 2000, available at: <http://frwebgate.access.gpo.gov/cgibin/getpage.cgi?position=all&page=s11866 &dbname=2000_record>. 82 Eric Lipton and Stephen Labaton, The Reckoning: Deregulator Looks Back, Unswayed, New York Times, November 16, 2008, available at: <http://www.nytimes.com/2008/11/17/busin ess/economy/17gramm.html?_r=1&pagewanted=1& em>. else s to substantiate it. The markets have worked better than you might have thought. 83 Others have a more reality-based view. Former SEC Commissioner Harvey J. Goldschmid, conceded that in hindsight, there s no question that we would have been better off if we had been regulating derivatives. 84 While credit default swaps are not the underlying cause of the financial crisis, they dramatically exacerbated it. As mortgages and mortgage-backed securities plummeted in value from declining real estate values, big financial firms were unable to meet their insurance obligations under their credit default swaps. Another action by Congress must be mentioned here. In 1995, bowing to the financial lobby after years of lobbying, Congress passed the Private Securities Litigation Reform Act. 85 The measure greatly restricted the rights of investors to sue Wall Street trading, accounting and investment firms for securities fraud. The author of the legislation was Representative 83 Eric Lipton and Stephen Labaton, Deregulator Looks Back, Unswayed, New York Times, November 16, 2008, available at: <http://www.nytimes.com/2008/11/17/busin ess/economy/17gramm.html?pagewanted=al l> 84 The Crash: What Went Wrong? Washington Post website, Undated, available at: <http://www.washingtonpost.com/wpsrv/business/risk/index.html?hpid=topnews> U.S.C. 78u-4.

49 SOLD OUT 49 Christopher Cox, R-California, who President Bush later appointed Chair of the Securities and Exchange Commission. In the debate over the bill in the House of Representatives, Representative Ed Markey, D-Massachusetts, proposed an amendment that would have exempted financial derivatives from the Private Securities Litigation Reform Act. 86 Markey anticipated many of the problems that would explode a decade later: All of these products have now been sent out into the American marketplace, in many instances with the promise that they are quite safe for a municipality to purchase. The objective of the Markey amendment out here is to ensure that investors are protected when they are misled into products of this nature, which by their very personality cannot possibly be understood by ordinary, unsophisticated investors. By that, I mean the town treasurers, the country treasurers, the ordinary individual that thinks that they are sophisticated, but they are not so sophisticated that they can understand an algorithm that stretches out for half a mile and was constructed only inside of the mind of this 26- or 28-year-old summa cum laude in mathematics from Cal Tech or from MIT who constructed it. No one else in the firm un- 86 Rep. Edward Markey, 104th Congress 1st Session, 141 Cong. Rec. H. 2826, March 8, 1995, available at: <http://frwebgate.access.gpo.gov/cgibin/getpage.cgi?dbname=1995_record&pag e=h2826&position=all>. derstands it. The lesson that we are learning is that the heads of these firms turn a blind eye, because the profits are so great from these products that, in fact, the CEOs of the companies do not even want to know how it happens until the crash. Representative Cox led the opposition to the Markey amendment. He was able to cite the opposition of Alan Greenspan, chair of the Federal Reserve, and President Clinton s SEC Chair Arthur Levitt. He quoted Greenspan saying that singling out derivative instruments for special regulatory treatment would be a serious mistake. He also quoted Levitt, who warned, It would be a grave error to demonize derivatives. 87 The amendment was rejected. The specter of litigation is a powerful deterrent to wrongdoing. The Private Securities Litigation Reform Act weakened that deterrent including for derivatives and today makes it more difficult for defrauded investors to seek compensation for their losses. 87 Rep. Christopher Cox, 104th Congress 1st Session, 141 Cong. Rec. H. 2828, March 8, 1995, available at: <http://frwebgate.access.gpo.gov/cgibin/getpage.cgi?position=all&page=h2828 &dbname=1995_record>.

50 50 SOLD OUT 5 THE SEC S VOLUNTARY REGULATION REGIME FOR INVESTMENT BANKS IN THIS SECTION: In 1975, the SEC s trading and markets division promulgated a rule requiring investment banks to maintain a debt-to-netcapital ratio of less than 12 to 1. It forbid trading in securities if the ratio reached or exceeded 12 to 1, so most companies maintained a ratio far below it. In 2004, however, the SEC succumbed to a push from the big investment banks led by Goldman Sachs, and its then-chair, Henry Paulson and authorized investment banks to develop their own net capital requirements in accordance with standards published by the Basel Committee on Banking Supervision. This essentially involved complicated mathematical formulas that imposed no real limits, and was voluntarily administered. With this new freedom, investment banks pushed borrowing ratios to as high as 40 to 1, as in the case of Merrill Lynch. This super-leverage not only made the investment banks more vulnerable when the housing bubble popped, it enabled the banks to create a more tangled mess of derivative investments so that their individual failures, or the potential of failure, became systemic crises. Former SEC Chair Chris Cox has acknowledged that the voluntary regulation was a complete failure. Until the current financial crisis, investment banks regularly borrowed funds to purchase securities and debt instruments. A highly leveraged financial institution is one that owns financial assets that it acquired with substantial amounts of borrowed money. The Securities and Exchange Commission (SEC) prohibited broker-dealers (i.e. stock brokers and investment banks) from exceeding established limits on the amount of borrowed money used for buying securities. Investment banks that accrued more than 12 dollars in debt for every dollar in bank capital (their net capital ratio ) were prohibited from trading in the stock market. 88 As a result, the five major Wall Street investment banks maintained net capital ratios far below the 12 to 1 limit. The rule also required broker-dealers to maintain a designated amount of set-aside capital based on the riskiness of their investments; the riskier the investment, the more they would need to set aside. This limitation on accruing debt was designed to protect the assets of customers with funds held or managed by the stock broker or investment bank, and to ensure that the broker or investment bank could meet its contractual obligations to other firms. 89 The rule was adopted by the C.F.R. 240, 15c Toxic Waste Build Up: How Regulatory Changes Let Wall Street Make Bigger Risky Bets, An Interview with Lee Pickard, Multinational Monitor, November/December 2008, available at: <http://www.multinationalmonitor.org/mm2

51 SOLD OUT 51 the aftermath of the 1929 crash. In 2004, the SEC abolished its 19-year old debt-to-net-capital rule in favor of a voluntary system that allowed investment banks to formulate their own rule. 90 Under this new scheme, large investment banks would assess their level of risk based on The SEC s Inspector General concluded that it is undisputable that the SEC failed to carry out its mission in its oversight of Bear Stearns, which collapsed in 2008 under massive mortgage-backed securities losses. SEC under the general regulatory authority The SEC s new policy, foreseeably, enabled investment banks to make much granted by Congress when it established the SEC to regulate the financial industry in greater use of borrowed funds. The top five 1934 as a key reform in investment banks participated in the SEC s voluntary program: Bear Steams, Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers. By 2008, these firms had borrowed 20, 30 and 40 dollars for each dollar in capital, far exceeding the standard 12 to 1 ratio. Much of the borrowed funds were used to purchase billions of dollars in subprime-related and their own risk management computer models. The SEC acted at the urging of the big and their associated derivatives, including other mortgage-backed securities (MBSs) investment banks led by Goldman Sachs, credit default swaps. The securities were which was then headed by Henry M. Paulson Jr., who would become Treasury secre- were skyrocketing and few predicted an end purchased at a time when real estate values tary two years later, and was the architect of to the financial party. As late as the March the Bush administration s response to the 2008 collapse of Bear Stearns, SEC Chair current financial debacle: the unprecedented Christopher Cox continued to support the taxpayer bailout of banks, investment firms, voluntary program: We have a good deal of insurers and others. After a 55-minute comfort about the capital cushions at these discussion, the SEC voted unanimously to firms at the moment, he said. 92 abolish the rule /112008/interview-pickard.html>. 90 Final Rule: Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Entities, 17 C.F.R. 200 and 240 (2004). Available at: <www.sec.gov/rules/final/ htm>. 91 Stephen Labaton, Agency s 04 Rule Let Banks Pile Up New Debt, New York Times, October 2, 2008, available at: <http://www.nytimes.com/2008/10/03/busin ess/03sec.html?_r=1>. 92 Stephen Labaton, Agency s 04 Rule Let Banks Pile Up New Debt, New York Times, October 2, 2008, available at: <http://www.nytimes.com/2008/10/03/busin

52 52 SOLD OUT The SEC had abolished the net capital rule with the caveat that it would continue monitoring the banks for financial or operational weaknesses. But a 2008 investigation by the SEC s Inspector General (IG) found that the agency had neglected its oversight responsibilities. The IG concluded that it is undisputable that the SEC failed to carry out its mission in its oversight of Bear Stearns, which collapsed in 2008 under massive mortgage-backed securities losses, leading the Federal Reserve to intervene with taxpayer dollars to prevent significant harm to the broader financial system. The IG said the SEC became aware of numerous potential red flags prior to Bear Stearns collapse, including its concentration of mortgage securities and high leverage, but did not take actions to limit these risk factors. Moreover, concluded the IG, the SEC was aware... that Bear Stearns concentration of mortgage securities was increasing for several years and was beyond its internal limits. Nevertheless, it did not make any efforts to limit Bear Stearns mortgage securities concentration. The IG said the SEC was aware that Bear Stearns leverage was high; but made no effort to require the firm to reduce leverage despite some authoritative sources describing a linkage between leverage and liquidity risk. Furthermore, the SEC became aware that risk management of mortgages at Bear Stearns ess/03sec.html?_r=1>. had numerous shortcomings, including lack of expertise by risk managers in mortgagebacked securities and persistent understaffing; a proximity of risk managers to traders suggesting a lack of independence; turnover of key personnel during times of crisis; and the inability or unwillingness to update models to reflect changing circumstances. Notwithstanding this knowledge, the SEC missed opportunities to push Bear Steams aggressively to address these identified concerns. The much-lauded computer models and risk management software that investment banks used in recent years to calculate risk and net capital ratios under the SEC s voluntary program had been overwhelmed by human error, overly optimistic assumptions, including that the housing bubble would not burst, and a failure to contemplate systemwide asset deflation. Similar computer models failed to prevent the demise of Long-Term Capital Management, a heavily leveraged hedge fund that collapsed in 1998, and the stock market crash of October The editors at Scientific American magazine lambasted the SEC and the investment banks for their [o]verreliance on financial software crafted by physics and 93 Stephen Labaton, Agency s 04 Rule Let Banks Pile Up New Debt, New York Times, October 2, 2008 (citing Leonard D. Bole, software consultant), available at: <http://www.nytimes.com/2008/10/03/busin ess/03sec.html?_r=1>.

53 SOLD OUT 53 math Ph.D.s. 94 By the fall of 2008, the number of major investment banks on Wall Street dropped from five to zero. All five securities grants either disappeared or became bank holding companies in order to avail themselves of taxpayer bailout money. JP Morgan bought Bear Stearns, Lehman Brothers filed for bankruptcy protection, Bank of America announced its rescue of Merrill Lynch by purchasing it, while Goldman Sachs and Morgan Stanley became bank holding companies with the Federal Reserve as their new principal regulator. On September 26, 2008, as the crisis became a financial meltdown of epic proportions, SEC Chair Cox, who spent his entire public career as a deregulator, conceded the last six months have made it abundantly clear that voluntary regulation does not work The Editors, After the Crash: How Software Models Doomed the Markets, Scientific American, November 2008, available at: <http://www.sciam.com/article.cfm?id=after -the-crash>. 95 Anthony Faiola, Ellen Nakashima and Jill Drew, The Crash: What Went Wrong, The Washington Post, October 15, 2008, available at: <http://www.washingtonpost.com/wpdyn/content/story/2008/10/14/st html>.

54 54 SOLD OUT 6 BANK SELF-REGULATION GOES GLOBAL: PREPARING TO REPEAT THE MELTDOWN? IN THIS SECTION: In 1988, global bank regulators adopted a set of rules known as Basel I, to impose a minimum global standard of capital adequacy for banks. Complicated financial maneuvering made it hard to determine compliance, however, which led to negotiations over a new set of regulations. Basel II, heavily influenced by the banks themselves, establishes varying capital reserve requirements, based on subjective factors of agency ratings and the banks own internal riskassessment models. The SEC experience with Basel II principles illustrates their fatal flaws. Commercial banks in the United States are supposed to be compliant with aspects of Basel II as of April 2008, but complications and intra-industry disputes have slowed implementation. Banks are inherently highly leveraged institutions, meaning they hold large amounts of debt compared to their net worth (or equity). As a result, their debt-to-equity (or debt-to-capital) ratios are generally higher than for other types of corporations. Regulators have therefore required banks to maintain an adequate cushion of capital to protect against unexpected losses, especially losses generated on highly leveraged investments. Generally, banks are required to keep higher capital amounts in reserve in order to hold assets with higher risks and, inversely, lower capital for lower risk assets. In other words, banks with riskier credit exposures are required to retain more capital to back the bank s obligations. In 1988, national bank regulators from the largest industrial countries adopted a set of international banking guidelines known as the Basel Accords. The Basel Accords determine how much capital a bank must hold as a cushion. Ultimately, the purpose of the Basel Accords is to prevent banks from creating a systemic risk, or a risk to the financial health of the entire banking system. The idea of an international agreement was to level the playing field for capital regulation as among banks based in different countries. The first Basel Accords, known as Basel I, did not well distinguish between loans involving different levels of risk. This gave rise to two sets of problems. Banks had an incentive to make riskier (and potentially higher return) loans, because the riskier loans within a given category did not require more set-aside capital. For example, Basel I categorized all commercial loans into the 8 percent capital category meaning 8 percent of a bank s capital must be set aside to hold commercial loans even though not all commercial loans are equivalently risky. The Basel I rules also gave banks an

55 SOLD OUT 55 incentive to engage in regulatory capital arbitrage, whereby a bank maneuvers the accounting classification of a loan so that it is classified under Basel I rules as requiring less set-aside capital even though the bank s overall risk has not diminished. Securitization is the main method used by banks to engage in regulatory capital arbitrage. Securitized loans are listed on a bank s trading account, which requires less set-aside capital than the banking book, where loans are maintained. 96 To address these problems, the Basel Committee on Banking Supervision agreed in 2004 to an updated bank capital accord (Basel II), formally known as the International Convergence of Capital Measurement and Capital Standards: a Revised Framework. The Committee s members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States; the United States Federal Reserve serves as a participating member. Rather than dealing directly with the issue of differentiated levels of risk within categories and the problem of regulatory 96 David Jones and John Mingo, Industry Practices in Credit Risk Modeling and Internal Capital Allocations: Implications for a Models-Based Regulatory Capital Standard, 4 FRBNY Econ. Pol y Rev. 3, 53 (1998), available at: <http://www.newyorkfed.org/research/epr/9 8v04n3/9810jone.pdf>. arbitrage by establishing updated and more granular capital standards, Basel II authorized banks to use their own internal models for assessing risk. Critics say that under this system, banks will be able to employ their internal risk models to transform highrisk assets into low risk. For example, where Basel I categorized all commercial loans into the 8 percent capital category, internal bank models would have allowed for capital allocations on commercial loans that vary from 1 percent to 30 percent, depending on the loan s estimated risk. The revised framework under Basel II gives banks the leeway to lump commercial loans into these differing capital adequacy requirements, depending on risk as estimated by banks, not the regulators. Basel II rules appear set to reduce the overall capital requirements for banks. 97 U.S. federal financial regulatory agencies the Federal Reserve, Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision have struggled to find an operationally satisfactory means to implement Basel II. It now appears U.S. application will be limited to large commercial banks only, with some Basel II 97 Testimony of Daniel K. Tarullo, Hearing on the Development of the New Basel Capital Accords, Committee on Banking, Housing and Urban Affairs, United States Senate, November, , available at: <http://banking.senate.gov/public/_files/taru llo.pdf>.

56 56 SOLD OUT requirements coming into effect via regulation as of April The Securities and Exchange Commission (SEC) imposed parallel requirements on Wall Street investment banks in According to the Federal Reserve, Basel II is supposed to improve the consistency of capital regulations internationally, make regulatory capital more risk sensitive, and promote enhanced riskmanagement practices among large, internationally active banking organizations. 99 But the SEC s experience with the Basel II approach reveals a fundamental flaw in allowing banks to make their own risk assessments. Investment bank Bear Stearns collapsed in 2008 even though its own risk analysis showed it to be a sound institution. SEC Chairman Christopher Cox said the rapid collapse of Bear Stearns... challenged the fundamental assumptions behind the Basel standards and the other program metrics. At the time of its nearfailure, Bear Stearns had a capital cushion 98 Office of the Comptroller of the Currency, Basel II Advanced Approaches and Basel II Standardized Approach, undated, available at: <http://www.occ.treas.gov/law/basel.htm>. 99 Basel II Capital Accord, Basel I Initiatives, and Other Basel-Related Matters, Federal Reserve Board, August 28, 2008, available at: <http://www.federalreserve.gov/generalinfo /basel2/>. The SEC s experience with the Basel II approach reveals a fundamental flaw in allowing banks to make their own risk assessments. well above what is required to meet supervisory standards calculated using the Basel framework and the Federal Reserve s wellcapitalized standard for bank holding companies. 100 In other words, Bear Stearns had been complying with the relaxed Basel II framework and it still failed. Proponents of Basel II argue that internal risk assessments will not be cause for abuse because regulators will be heavily involved via added oversight and disclosure. Five years before the 2008 financial crisis, John D. Hawke, Jr., then U.S. Comptroller of the Currency, lauded the Basel II standards, arguing that some have viewed the new Basel II approach as leaving it up to the banks to determine their own minimum capital putting the fox in charge of the chicken coop. This is categorically not the case. While a bank s internal models and risk assessment systems will be the starting point for the calculation of capital, bank supervisors will be heavily involved at every stage of the process Chairman Christopher Cox, Before the Committee on Oversight and Government Reform, U.S. House of Representatives, October 23, 2008, available at: <http://oversight.house.gov/documents/ pdf>. 101 John D. Hawke, Jr., Comptroller of the Currency, Before the Committee on Bank-

57 SOLD OUT 57 But the Comptroller s claim is not supported by the SEC s experience. The SEC s Inspector General (IG) found that regulators were anything but heavily involved in oversight of Bear Stearns in the years before its collapse. As noted above (Part I.5), the IG concluded that it is undisputable that the SEC failed to carry out its mission in its oversight of Bear Stearns. The banks internal risk models performed horribly in the housing bubble and subsequent meltdown. It s hard to see the logic of a system that would embed those models into regulatory requirements for setaside capital. 102 ing, Housing, and Urban Affairs, United States Senate, June 18, 2003, available at: <http://frwebgate.access.gpo.gov/cgibin/getdoc.cgi?dbname=108_senate_hearing s&docid=f:94514.pdf>. 102 Steven Sloan, Another Reason to Disagree Over Basel, American Banker, January 6, 2009, available at: <http://www.aba.com/aba/documents/icaa P_WG/Sloan_AB_ pdf>. ( I am most concerned that any institution that tends to underestimate its risk exposure as many recently have will be just as likely to underestimate its capital needs if allowed to operate a risk-based capital standard, such as Basel II, Mr. Hoenig [the president and chief executive of the Federal Reserve Bank of Kansas City] said. Riskbased capital standards may also encourage institutions to lower their capital, instead of build it up, in the prosperous times that typically precede a crisis. )

58 58 SOLD OUT 7 FAILURE TO PREVENT PREDATORY LENDING IN THIS SECTION: Even in a deregulated environment, the banking regulators retained authority to crack down on predatory lending abuses. Such enforcement activity would have protected homeowners, and lessened though not prevented the current financial crisis. But the regulators sat on their hands. The Federal Reserve took three formal actions against subprime lenders from 2002 to The Office of Comptroller of the Currency, which has authority over almost 1,800 banks, took three consumer-protection enforcement actions from 2004 to Subprime loans are those made to persons who ostensibly have a poor credit history. Predatory loans are, to a significant extent, a subset of subprime loans. 103 A bank is engaged in predatory lending when it tak[es] advantage of a borrower s lack of sophistication to give them a loan whose rates and terms may not be beneficial to the borrower. 104 Common predatory terms 103 Non-prime mortgages known as Alt-A with riskier borrower profiles than prime mortgages but less so than subprime also often contain predatory terms. 104 The Foreclosure Epidemic: The Costs to Families and Communities of the Predictable Mortgage Meltdown, An interview include high fees and charges associated with the loan; low teaser interest rates, which skyrocket after an initial grace period; and negative amortization loans, which require, for a time, monthly payments less than the interest due. These are, typically, unaffordable loans. The real-world examples of predatory lending are shocking. In one lawsuit, Albert Zacholl, a 74-year-old man living in Southern California, alleges that Countrywide and a pair of mortgage brokers cold-called and aggressively baited him. They promised him $30,000 cash, a mortgage that would replace his previous mortgage (which was leaving him owing more each month) and a monthly payment that would not exceed $1,700. Zacholl told the brokers that his income consisted of a pension of $350 a month and Social Security payments of $958, and that with help from his son, he could afford a mortgage up to $1,700. According to the lawsuit, the broker falsified his loan application by putting down an income of $7,000 a month, and then arranged for a high-interest mortgage that required him to pay more than $3,000 a month (and failed to deliver the $30,000 cash payment). The motivation for the scam, according to the lawsuit, was to collect with Allen Fishbein, Consumer Federation of America, Multinational Monitor, May/June 2007, available at: <http://www.multinationalmonitor.org/mm2 007/052007/interview-fishbein.html>.

59 SOLD OUT 59 $13,000 in fees. In court papers, the Center for Responsible Lending reports, Countrywide responded that Zacholl consented to the terms of the transaction and that any problems were the result of his own negligence and carelessness. 105 Preventing predatory lending practices would not have prevented the housing bubble and the subsequent financial meltdown, but it would have taken some air out of the bubble and softened the economic crisis and it would have saved millions of families and communities across the country from economic ruin. Unlike the housing bubble itself, predatory lending was easily avoidable through sound regulation. But federal regulators were asleep at the switch, lulled into somnolence by cozy relationships with banks and Wall Street and a haze-inducing deregulatory ideology. Regulators were warned at the outset of the housing bubble about the growth in predatory lending, and public interest advocates pleaded with them to take action. They declined, refusing either to issue appropriate regulatory rules or to take enforcement actions against predatory lenders. (Congress similarly failed to act in response to the 105 Center for Responsible Lending, Unfair and Unsafe: How Countrywide s irresponsible practices have harmed borrowers and shareholders, February 2008, available at: <http://www.responsiblelending.org/issues/ mortgage/countrywide-watch/unfair-andunsafe.html>. alarm bells sounded by public interest advocates.) Reviewing the record of the past seven years shows that: 1. Federal regulators and Members of Congress were warned at the outset of the housing bubble about the growth in predatory lending, and public interest advocates pleaded with them to take action. 2. Federal regulators and Congress refused to issue appropriate regulatory rules to stem predatory lending. 3. Action at the state level showed that predatory lending rules could limit abusive loans. 4. Federal regulators failed to take enforcement actions against predatory lenders. 5. After the housing bubble had popped, and the subprime lending industry collapsed, federal regulators in 2008 issued new rules to limit predatory practices. While highly imperfect, the new rules evidence what might have been done in 2001 to prevent abuses. Early Warnings on Predatory Lending Yield No Regulatory Action There are only limited federal substantive statutory requirements regarding predatory lending. These are established in the Home

60 60 SOLD OUT Ownership and Equity Protection Act (HOEPA), which was adopted in HOEPA effectively put an end to certain predatory practices, but only for loans containing upfront fees or charges of more than 8 percent of the loan amount, or interest rates above a varying, but very high threshold. Predatory lenders easily devised ways to work around these limitations. In 2000 and 2001, the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve and the Office of Thrift Supervision, among other federal agencies, adopted or considered rules to further restrict predatory lending. The adopted binding rules, issued by the Federal Reserve pursuant to HOEPA, however, focused very narrowly on certain egregious practices. 106 More expansive statements on predatory lending were issued only as non-binding guidelines. The reliance on non-binding guidelines continued through the decade. As regulators were issuing non-binding guidelines, public interest advocates were praising their recognition of the problem but urging that more forceful action be C.F.R. 226 (Regulation Z; Docket No. R- 1090), 66 Fed. Reg. 245, (2001) (adjusting the price trigger for coverage under HOEPA and prohibiting certain acts). taken. Unlike the housing bubble itself, predatory lending was easily avoidable through sound regulation. But federal regulators were asleep at the switch. Clearly, the FDIC recognizes that there is a grave problem throughout the U.S., particularly affecting low income and minority households and neighborhoods, wrote the National Consumer Law Center and the Consumer Federation of America in January 2001 comments submitted to the FDIC. While many regulators recognize the gravity of the predatory lending problem, the appropriate and politically feasible method of addressing the problem still appears elusive. 107 What was needed, the consumer groups argued, was binding regulation. All agencies should adopt a bold, comprehensive and specific series of regulations to change the mortgage marketplace, the groups wrote, so that predatory mortgage practices are either specifically prohibited, or are so costly to the mortgage lender that they are not economically feasible while ensuring that necessary credit is made available with appropriate rates and terms to all Ameri- 107 National Consumer Law Center and the Consumer Federation of America, How to Avoid Purchasing or Investing in Predatory Mortgage Loans, January 31, 2001, available at: <http://www.nclc.org/issues/predatory_mort gage/fdic.shtml>.

61 SOLD OUT 61 cans. 108 Public interest groups would repeat this advice again and again over the subsequent years, pointing to growing abuses and proposing specific remedies. But federal agencies, operating under the prevailing laissez-faire ideology of the Bush Administration, declined to issue any binding regulations in response to mushrooming predatory lending. They did issue additional guidance statements, but these were non-binding and consistently behind the curve of evolving lender abuses. Not surprisingly, they failed to curtail predatory lending practices. A Failure to Enforce Federal regulators also failed to enforce the rules that were on the books. From 2003 through the start of 2007, the Federal Reserve, which has jurisdiction over the entire banking industry, took a mere three formal enforcement actions 109 to stop 108 National Consumer Law Center and the Consumer Federation of America, How to Avoid Purchasing or Investing in Predatory Mortgage Loans, January 31, 2001, available at: <http://www.nclc.org/issues/predatory_mort gage/fdic.shtml>. 109 Generally, the Federal Reserve takes formal enforcement actions against [banks] for violations of laws, rules, or regulations, unsafe or unsound practices, breaches of fiduciary duty, and violations of final orders. Formal enforcement actions include cease and desist orders, written agreements, removal and prohibition orders, and orders assessing civil money penalties. The Federal Reserve Board, Enforcement Actions, available at: predatory lending. 110 The Office of the Comptroller of the Currency (OCC), which has regulatory authority over roughly 1,800 nationally chartered banks, similarly took three public enforcement actions from 2004 to These numbers reflect a startling regulatory failure during the peak period of abusive subprime lending. Subprime loans made up between one-in-six and one-in-five home mortgage loans in 2004, 2005 and Although Federal Reserve officials now acknowledge that they should have done more, the OCC says it took appropriate action. Both agencies insist that they also addressed abuses on an informal, bank-bybank basis, ordering improved practices in connection with the agency s routine examinations of individual banks. The informal and non-public nature of this approach <http://www.federalreserve.gov/boarddocs/e nforcement>. 110 James Tyson, Craig Torres and Alison Vekshin, Fed Says It Could Have Acted Sooner on Subprime Rout, Bloomberg, March 22, 2007, available at: <http://www.bloomberg.com/apps/news?pid = &sid=a1.KbcMbvIiA&refer=ho me>. 111 Craig Torres and Alison Vekshin, Fed, OCC Publicly Chastised Few Lenders During Boom, Bloomberg, March 14, 2007, available at: <http://www.bloomberg.com/apps/news?pid = &sid=a6WTZifUUH7g&refer=u s>. 112 Chris Mayer and Karen Pence, Subprime Mortgages: What, Where and to Whom, Figure 1B, Federal Reserve, 2008, available at: <http://www.federalreserve.gov/pubs/feds/2 008/200829/200829pap.pdf>.

62 62 SOLD OUT means that Fed and OCC s claims cannot be easily verified. Even if there were extensive private enforcement actions or conversations, such moves fail to perform important public functions. They do not signal appropriate behavior and clear rules to other lenders; and they do not provide information to victimized borrowers, thereby depriving them of an opportunity to initiate follow-on litigation to recover for harms perpetrated against them. State Action Shows What Could Have Been Done While federal regulators sat on their hands, some states adopted meaningful antipredatory lending laws and brought enforcement actions against abusive lenders. This report does not explore state regulatory successes and failures, but the ability of states to regulate and address abusive lender behavior demonstrates what federal regulators might have done. A comprehensive review of subprime loans conducted by the Center for Responsible Lending found that aggressive state regulatory action greatly reduced the number of predatory loans, without affecting Federal agencies, operating under the prevailing laissezfaire ideology of the Bush Administration, declined to issue any binding regulations in response to mushrooming predatory lending. borrowers access to subprime credit. States with anti-predatory lending laws reduced the proportion of loans with targeted [predatory] terms by 30 percentage points, the study determined. Even this number masked the superior performance of those with the toughest laws. States with the strongest laws Massachusetts, New Jersey, New Mexico, New York, North Carolina, and West Virginia are generally associated with the largest declines in targeted terms relative to states without significant protections, the study found. 113 The Center for Responsible Lending study also concluded that lending continued at a constant rate in states with antipredatory lending laws, and that state laws have not increased interest rates and, in some cases, borrowers actually paid lower rates for subprime mortgages after their state laws became effective compared to borrowers in states without significant protections. In other words, eliminating abusive fees did not translate into higher interest rates Wei Li and Keith S. Ernst, The Best Value in the Subprime Market: State Predatory Lending Reforms, Center for Responsible Lending, February, 23, 2006, available at: <http://www.responsiblelending.org/pdfs/rr0 10-State_Effects-0206.pdf>. 114 Wei Li and Keith S. Ernst, The Best Value in the Subprime Market: State Predatory

63 SOLD OUT 63 Partially Closing the Barn Door (after the horses left and a foreclosure sign is posted) After years of inaction, and confronted with signs of the economic meltdown to come, the Federal Reserve in January 2008 finally proposed binding regulations that would apply to all lenders, not just nationally chartered banks. The Federal Reserve proposal noted the growth of subprime mortgages, claimed the expansion of subprime credit meaningfully contributed to increases in home ownership rates (a gain quickly unraveling due to the subprime-related foreclosure epidemic) and modestly suggested that [r]ecently, however, some of this benefit has eroded. In the last two years, delinquencies and foreclosure starts have increased dramatically and reached exceptionally high levels as house price growth has slowed or prices have declined in some areas. 115 With slight modification, the Fed adopted these rules in July. 116 The new regulations establish a new category of higher-priced mortgages intended to include virtually all subprime loans. The regulations prohibit a number of abusive practices in connection with these newly Lending Reforms, Center for Responsible Lending, February, 23, 2006, available at: <http://www.responsiblelending.org/pdfs/rr0 10-State_Effects-0206.pdf>. 115 Federal Reserve System, Truth In Lending, 73 Fed. Reg. 6, (2008). 116 Federal Reserve System, 12 C.F.R. 226, [Regulation Z; Docket No. R-1305], 73 Fed. Reg. 147, (2008). defined higher-priced mortgages. 117 They also apply some measures such as specified deceptive advertising practices for all loans, regardless of whether they are subprime Key elements of these regulations: Prohibit a lender from engaging in a pattern or practice of making loans without considering the borrowers ability to repay the loans from sources other than the home s value. Prohibit a lender from making a loan by relying on income or assets that it does not verify. Restrict prepayment penalties only to loans that meet certain conditions, including the condition that the penalty expire at least sixty days before any possible increase in the loan payment. Require that the lender establish an escrow account for the payment of property taxes and homeowners insurance. The lender may only offer the borrower the opportunity to opt out of the escrow account after one year. 118 These regulatory provisions, applying to all mortgages, regardless of whether they are subprime: Prohibit certain servicing practices, such as failing to credit a payment to a consumer s account when the servicer receives it, failing to provide a payoff statement within a reasonable period of time, and pyramiding late fees. Prohibit a creditor or broker from coercing or encouraging an appraiser to misrepresent the value of a home. Prohibit seven misleading or deceptive advertising practices for closed-end loans; for example, using the term fixed to describe a rate that is not truly fixed. It would also require that all applicable rates or payments be disclosed in advertisements with equal prominence as advertised introductory or teaser rates. Require truth-in-lending disclosures to borrowers early enough to use while shopping for a mortgage. Lenders could not charge fees until after the consumer receives the disclosures, except a fee to

64 64 SOLD OUT tected, argue the consumer and housing groups. They provide an extensive list of needed revisions to the proposed regulations, including that the regulations: Cover all loans, including prime loans; Require an ability to repay analysis for each loan; Ban prepayment penalties; Address lender and originator incentives for appraisal fraud; and Provide effective private litigation remedies for victimized borrowers. 120 These measures are not inconsequential. They show the kind of action the Federal Reserve could have taken at the start of this decade moves that could have dramatically altered the subsequent course of events. But the 2008 regulations remain inadequate, as a coalition of consumer and housing groups has specified in great detail, 119 because they fail to break with longstanding deregulatory nostrums. The Fed continues to emphasize the importance of enabling lenders to make credit available to minority and lower-income communities historically, a deep-rooted concern while failing to acknowledge that the overriding problem has become lenders willing to make credit available, but on abusive terms. The proposed regulations continue to be most protective of the flawed concept that access to credit should be the guiding principle for credit regulation. These regulations need to be significantly strengthened in order for consumers to be adequately proobtain a credit report. 119 National Consumer Law Center, Consumer Action, Consumer Federation of America, Consumers Union, Leadership Conference on Civil Rights, National Association of Consumer Advocates, National Fair Housing Alliance, and the Empire Justice Center ( National Consumer Law Center et. al. ), Comments to the Board of Governors of the Federal Reserve System Regarding Proposed Regulations Relating to Unfair Trade Practices In Connection with Mortgage Lending, April 2008, available at: <http://www.consumerfed.org/pdfs/hoepa _comments_nclc_final.pdf>. 120 National Consumer Law Center, et. al., Comments to the Board of Governors of the Federal Reserve System Regarding Proposed Regulations Relating to Unfair Trade Practices In Connection with Mortgage Lending, April 2008, available at: <http://www.consumerfed.org/pdfs/hoepa _comments_nclc_final.pdf>.

65 SOLD OUT 65 ORIGINS OF THE HOUSING BUBBLE The housing bubble can be traced to a series of inter-related developments in the macro-economy, themselves due in significant part to political choices. First, the Federal Reserve lowered interest rates to historically low levels in response to the economic downturn that followed the collapse of the stock market bubble of the 1990s and the additional economic slowdown after 9/11. Low interest rates had beneficial effects in spurring economic activity, but they also created the conditions for the housing bubble, as cheap credit made mortgage financing an attractive proposition for home buyers. Cheap credit was not a result only of Fed interest rate decisions. A second contributing factor to the housing bubble was the massive influx of capital into the United States from China. China s capital surplus was the mirror image of the U.S. trade deficit U.S. corporations were sending dollars to China in exchange for goods sold to U.S. consumers. China then reinvested much of that surplus in the U.S. bond market, with the effect of keeping U.S. interest rates low. Cheap credit did not automatically mean there would be a housing bubble. Crucially, government officials failed to intervene to pop the housing bubble. As economists Dean Baker and Mark Weisbrot of the Center for Economic and Policy Research insisted at the time, simply by identifying the bubble and adjusting public perception of the future of the housing market Federal Reserve Chair Alan Greenspan could have prevented or at least contained the bubble. He declined, and even denied the existence of a bubble. There were reasons why Greenspan and other top officials did not act to pop the bubble. They advanced expanded home ownership as an ideological goal. While this objective is broadly shared across the political spectrum, the Bush administration and Greenspan s ideological commitment to the goal biased them to embrace growing home buying uncritically without regard to whether new buyers could afford the homes they were buying, or the loans they were getting. Perhaps more importantly, the housing bubble was the engine of an

66 SOLD OUT 67 8 FEDERAL PREEMPTION OF STATE CONSUMER PROTECTION LAWS IN THIS SECTION: When the states sought to fill the vacuum created by federal nonenforcement of consumer protection laws against predatory lenders, the feds jumped to stop them. In 2003, as Eliot Spitzer recounted, during the height of the predatory lending crisis, the Office of the Comptroller of the Currency invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. In 2003, the Comptroller of the Currency, John D. Hawke, Jr., announced that he was preempting state predatory lending laws. This ruling meant that nationally chartered banks which include the largest U.S. banks would be subject to federal banking standards, but not the more stringent consumer protection rules adopted by many states. The Comptroller s decision was a direct response to a request from the nation s biggest banks. It was prompted by a petition from Cleveland-based National City Bank, which challenged the application of the Georgia Fair Lending Act to its operations in Georgia. The Comptroller agreed with National City s contention that the federal banking laws, the history of federal regulation of national banks and relevant legislative history all supported the conclusion that federal regulatory authority should supersede and override any state regulation regarding predatory lending. 121 In its petition, National City argued that the effect of the Georgia law is to limit National City s ability to originate and to establish the terms of credit on residential real estate loans and lines of credit, including loans or lines of credit submitted by a third party mortgage broker. GFLA [the Georgia Fair Lending Act] has significantly impaired National City s ability to originate residential real estate loans in Georgia. It is instructive to identify the provisions of the Georgia law, a path breaking anti-predatory lending initiative, to which National City objected. The Georgia law included a wide range of consumer protections that consumer groups applauded but which National City complained would interfere with its freedom to operate: GFLA establishes specific and burdensome limitations on mortgage secured loans and lines of credit that significantly interfere with National City s ability to 121 Office of the Comptroller of the Currency [Docket No ] Preemption Determination and Order, august 5, 2003, Federal Register, Vol No. 150, )

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